KRUKZIENER V COMMISSIONER OF INLAND REVENUE HC AK CIV-2010-404-000728

KRUKZIENER V COMMISSIONER OF INLAND REVENUE HC AK CIV-2010-404-000728 17 September 2010IN THE HIGH COURT OF NEW ZEALAND AUCKLAND REGISTRY CIV-2010-404-000728BETWEEN ANDREW MARK KRUKZIENER Appellant AND COMMISSIONER OF INLAND REVENUE Respondent Hearing: 8 June 2010 Appearances: M T Lennard for Appellant H Ebersohn for Respondent Judgment: 17 September 2010 at 3:30 pmJUDGMENT OF COURTNEY JThis judgment was delivered by Justice Courtney on 17 September 2010 at 3:30 pm pursuant to R 11.5 of the High Court Rules. Registrar / Deputy Registrar Date. Solicitors: Crown Law, P O Box 2858, Wellington 6140 Fax: (04) 473-3482 – H Ebersohn Knight Coldicutt, Private Box 106214, Auckland Fax: (09) 309-2777Counsel: M T Lennard, P O Box 117, Lambton Quay, Wellington 6140 Fax: (04) 472-9029Introduction[1] Mr Krukziener is a property investor and developer who operates through a group of companies and trading trusts. Over the period 1991-2002, these entities completed many successful developments and acquired valuable investments. During that period, Mr Krukziener received only a very modest amount by way of salary from the group. However, he received nett funds totalling $5,094,442 through current accounts with trusts and companies forming part of his group. [2] Mr Krukziener maintained that he received these funds as loans and was not obliged to pay income tax on them. The Commissioner considered that the funds were part of a tax-avoidance arrangement and should be reconstructed as income, rendering Mr Krukziener liable for both income tax and penalties. The Taxation Review Authority (the "TRA") upheld the Commissioner. 1[3] Mr Krukziener appeals the TRA's decision, asserting that: a) The TRA took the wrong approach in determining what constitutes an arrangement for the purposes of the relevant legislation and that no arrangement existed; b) Even if there was an arrangement, it did not have tax avoidance as its purpose or effect. [4] The relevant provisions over the period 1991-2002 were s 99 of the Income Tax Act 1976, s BB9 of the Income Tax Act 1994 and s BG1 of the Income Tax Act 1994. These provisions are the same in all material respects.1 Krukziener v Commissioner of Inland Revenue NZTRA 03/08, 27 January 2010Was there an arrangement?What constitutes an arrangement?[5] Under the relevant legislation an arrangement is a contract, agreement, plan or understanding (whether enforceable or unenforceable) including all steps and transactions by which it is carried into effect. 2[6] In AMP Life v CIR, 3 McGechan J held that the discrete steps relied on by the Commissioner in that case, as amounting to an arrangement, were not sufficient because: 4They are a mere sequence of events, each with knock-on causative consequences, but that situation does not suffice. The concepts of contract, agreement, plan or understanding predicate some prior planned linking or sequencing or both, and that element is missing.[7] In the present case, referring to AMP Life, the TRA correctly identified the need for an arrangement to be more than merely discrete steps, observing that:5These transactions must apply in a concerted way as part of a predetermined end.TRA's finding[8] Since about 1985, Mr Krukziener, through various entities, undertook over 80 property investments or developments. Overall management and control of these projects lay with the Felix Trust during the period 1988-1996, and with Krukziener Properties Limited (KPL) 6 from 1996-2002. Each project was undertaken by a separate entity, usually a trading trust but sometimes a company, created for that purpose. In most instances, Mr Krukziener was a beneficiary or shareholder. There was nothing remarkable about this structure; it is one commonly adopted to isolate the creditor risks associated with individual projects so as to avoid affecting the rest of a group.2 Income Tax Act 1994, s OB1; Income Tax Act 1976, s 23 AMP Life v CIR (2000) 19 NZTC 15,940 (HC)4 At [125]5 Krukziener v Commissioner of Inland Revenue NZTRA 03/08, 27 January 2010 at [25][9] Although Mr Krukziener is best known for the ill-fated Metropolis project, most of the projects were profitable. Mr Sheppard, an accountant and a former trustee of the Felix Trust, described how profits were distributed; at the completion of a project, the trustees of the trading trust had a discretion to either pay tax on the profit as trustee income or allocate the profit to a beneficiary, with the beneficiary liable to pay tax on it. Although Mr Krukziener was usually a beneficiary, no profit was ever allocated to him. Typically, the trustees would nominate the trading trust that was undertaking the next project as a beneficiary and distribute the profit to that trust. That next project would be in its early stages and accumulating losses which could be offset against the profit with the result that no tax was payable on the distribution. [10] Throughout the relevant period, Mr Krukziener held a current account with the Felix Trust, KPL and other entities. His evidence was that he did not receive wages or a salary from any part of the group; his financial return was to be the distribution of profits from successful projects. Pending such distributions, Mr Krukziener's living expenses were met from advances made to him by these entities through the current accounts (usually through the payment of his personal credit card debts). [11] Although these advances were recorded as loans, there was no agreement regarding repayment of them. There was no evidence of demand for repayment ever having been made and funds advanced by the Felix Trust remain outstanding. However, from 1997 onward, Mr Krukziener made repayments to KPL, clearing the remaining indebtedness in 2002. These repayments were made from a non-taxable capital distribution made to him following the sale of a property owned by one of the group. [12] The Commissioner argued that an arrangement existed, comprising the following steps: a) Mr Krukziener borrowed funds from the Felix Trust, KPL and other associated entities;6 Renamed Auckland Management Limited in 2002b) There was no defined date for repayment or interest payable (except for the debt to KPL in 2001-2002); c) No (or only slight, depending on the income year) taxable distributions or amounts were paid by the associated entities/trusts to Mr Krukziener, with repayments of the loans being made from non- taxable distributions received from associated entities. [13] The TRA accepted this argument and also considered that each income year should be regarded as a separate arrangement:[29] It is submitted for the defendant that, in the current context, these steps cannot be explained in terms of ordinary commercial purposes; they can only be explained in terms of a concerted series of steps aimed at obtaining a tax benefit; and each income year can be viewed as a separate arrangement as, in each income year, the disputant would be required to decide what drawings to take and how these would be dealt with. I agree.[14] Mr Lennard, for Mr Krukziener, argued that these steps did not amount to an arrangement but were, as described in AMP Life, "a mere sequence of events each with knock-on causative consequences". 7 He also argued that, not only do the steps relied on not constitute an arrangement, but the Commissioner's reconstruction depends on events that occurred years after the steps took place and were never envisaged at the time. Therefore, the reconstruction has a retrospective effect that offends against the rule of law.Was there an arrangement?[15] Mr Lennard argued that the TRA's conclusion does not reflect the largely unchallenged evidence that Mr Krukziener gave as to the circumstances that resulted in the current account deficits and the expected source of repayments of the loans. He also argued that the TRA wrongly took into account the fact that the repayments by Mr Krukziener to KPL were made from non-taxable capital distributions. In advancing these arguments, Mr Lennard submitted that the evidence Mr Krukziener and other witnesses gave as to what they believed they had agreed, planned and7 AMP Life v Commissioner of Inland Revenue (2000) 19 NZTC 15,940 (HC) at [125]understood, was admissible as evidence of what the arrangement actually was. I do not accept this. Evidence of what Mr Krukziener and other witnesses actually said and did at the relevant times is relevant and helpful. However, subjective evidence of what they claim to have believed or intended is not. [16] Mr Krukziener gave evidence as to the practice among property developers of borrowing against the future success of a project to fund their living expenses:[17] The property industry requires both nerves and patience. From the beginning of a project it requires constant payments and outflows of funds, often with no corresponding inward cashflows. It may take months or even years for positive cash flows to be generated by a project. Those in the industry are prepared to weather this disadvantage due to the potentially large profits that can be generated, which hopefully recoup all outflows and generate a positive return over the life of the project. But during a project there may be little if any cashflow on which to live. Unlike other industries with predictable or periodic cashflows the long delay before any profit is realised means that the proprietors must find another way to fund their ongoing living expenses. In the property industry, proprietors are obliged to fund their living costs by, effectively, borrowing against the future success of that project. A proprietor cannot wait for each project to mature and generate a profit but must somehow find a way to fund their daily living costs. While it may not be common in other industries, it is entirely common in the property industry to live off funds borrowed from the development. In effect the proprietor draws down on the expected future profits of the project.(emphasis added)[17] Mr Sheppard gave similar evidence, as did Mr Milton, an accountant whose firm acted for the Krukziener group. However, the general practice of property developers borrowing to fund living expenses pending the completion of a project was not, in itself, controversial. The Commissioner's argument focused on the way this practice was implemented by Mr Krukziener; there was no defined date for repayment, no requirement to pay interest and since Mr Krukziener controlled the distribution of profits from the various projects, repayments could be (and were) made only when non-taxable capital distributions became available. [18] On the issue of whether advances were required to be repaid, and when, Mr Krukziener said:.......Crucially, these drawings are expected to be repaid from the profits of that project or other projects when they mature. When funds becomeavailable they are applied to repay the current account. If the project succeeds, any surplus may be distributed to the proprietor or can be re- invested into a new project.[19] Mr Sheppard confirmed that advances made to Mr Krukziener by the Felix Trust were to be repaid. He said that during his time as a trustee of the Felix Trust, he was aware that Mr Krukziener drew funds down to fund living expenses. However, he was unaware of the extent of the drawings or their purpose at the time they were made. In relation to repayment he said that:I treated all such drawings as advances and anticipated that such advances would in due course be repaid[20] However, as the TRA found, whilst Mr Krukziener and Mr Sheppard may have anticipated that the advances would be repaid, their evidence did not go so far as to suggest that there was any specific arrangement for repayment, nor that demand for repayment was ever made. Save for 1991, there were net current account advances owing throughout the period of Mr Sheppard's trusteeship of the Felix Trust; Mr Krukziener paid the Felix Trust a total of $175,820, but drew a total of $555,732. This left a net amount of $379,911.90 owing at the end of that period, which has never been repaid. [21] Mr Milton also said that drawings were expected to be repaid. He was not aware of any deed, agreement, resolution or journal entry remitting or forgiving the advances and therefore "would consider the accounting treatment of the advances, made to Mr Krukziener and recorded in his current accounts to remain a debt owed by him". However, Mr Milton did not point to any specific instance of a demand for repayment. Save for a payment of $391,988 by Mr Krukziener to KPL in 1996, the KPL current account deficit steadily increased until 2003 when the entire indebtedness was cleared. [22] Despite there being no evidence of any requirement for repayment of the current account drawings within a particular time, nor evidence of any demand for repayment, Mr Krukziener did make some significant repayments. Mr Lennard put weight on the fact of these repayments, particularly that the indebtedness to KPL was cleared in 2003. However, apart from a repayment to KPL in 2002, Mr Krukzienerwas not specific as to the source of money used for the repayments. He said that they were made through a combination of credit transfers from other group entities and cash payments. He gave two examples. One was the application, in 2001, of a capital distribution of $7,935.18 from another entity in the group to partially repay his current account. The other was the application, in 2002, of the proceeds of the sale of shares. The single largest repayment over the period was a payment of $3,663,146.57 to KPL in 2002, made using capital distributed to Mr Krukziener by the AK360 Investment Trust. The distribution followed the sale of a commercial property in the face of pressure associated with the Metropolis project. [23] The TRA accepted the Commissioner's argument that a significant indicator of the existence of an arrangement was the fact that the current account advances were repaid only when non-taxable distributions became available. Mr Lennard submitted that this finding depended on events that occurred years after the advances were made and were never envisaged at the time and therefore could not fairly be said to have been part of any arrangement. Mr Ebersohn submitted, in response, that the use of this distribution simply illustrated the manner in which the arrangement operated; namely that advances were repaid only from capital distributions which would not attract tax. Since Mr Krukziener controlled both the lenders (as trustee of the Felix trust and director of KPL) and the trusts making the capital distributions, he effectively controlled when and from what source repayments would be made. [24] Looking back over the relevant period, there emerges a pattern of substantial advances in respect of which only sporadic repayments were made, seemingly at the will of Mr Krukziener and, apparently, coinciding with the availability of non- taxable capital distributions. The ever-increasing level of advances, coupled with the relative lack of repayments over a long period of time, suggests a deliberate plan that there would be no requirement for Mr Krukziener to repay the advances unless and until there was a capital distribution available to apply for that purpose. I therefore find that the TRA was correct in holding that an arrangement existed. [25] I turn, then, to the question of whether there was more than one arrangement. There can be no doubt that over a period of time, there may be more than onearrangement. It is a question to be determined on the evidence. 8 The TRA held that there was a separate arrangement for each income year. Mr Lennard submitted that this was erroneous. For convenience, I discuss this point together with Mr Lennard's submission that the TRA's decision offends against the rule of law, which requires laws to be clear and predictable. To this end, legislation should therefore be interpreted to avoid retrospective effect. [26] Mr Lennard submitted that income tax, as an annual liability, ought to be determinable year on year and that a taxpayer must know his or her taxable income shortly after the end of each tax year. Looking at each year in isolation, there was no basis on which to find an arrangement. Instead, all that existed in any particular year was a drawing taken by the appellant in the hope and expectation of repaying it from some source at a future stage. I have already held that the pattern of advances and repayments points to an arrangement. Examining each year in isolation does not change this. The advances were made by different entities and Mr Krukziener received them in different capacities e.g. as a beneficiary of the Felix Trust or as shareholder of KPL. They were recorded in the annual statements of financial position for the various entities. In these circumstances, the TRA's conclusion that there was more than one arrangement was inevitable. [27] I accept that, had this assessment been made at the end of, for example, 1991 or 1992, ascertaining whether an arrangement existed may have been more difficult. However, the TRA was able to consider the pattern of advances and repayments over a very long period. Further, contrary to what Mr Lennard submitted, I do not consider that such a finding contravenes the rule of law or is otherwise unfair to the taxpayer. By identifying the arrangements, the TRA has done no more than state the position that has always existed and has been known by the tax payer to have always existed. The finding has no retrospective effect.8 Peterson v Commissioner of Inland Revenue [2006] 3 NZLR 433 (PC) at [33].Was the purpose and effect of the arrangement tax avoidance?Relevant principles[28] Under the relevant legislation: 9a) Every arrangement made or entered into is void as against the Commissioner for income tax purposes if and to the extent that, directly or indirectly –• Its purpose or effect is tax avoidance; or• Where it has two or more purposes or effects, one of its purposes or effects (not being merely incidental purpose or effect) is tax avoidance, whether or not any other or others of its purposes or effects relate to, or are referrable to, ordinary business or family dealings. b) Tax avoidance includes:• Directly or indirectly altering the incidence of any income tax;• Directly or indirectly relieving any person from liability to pay income tax;• Directly or indirectly avoiding, reducing or postponing any liability to income tax. [29] In a case such as this, where the taxpayer asserts the use of a normal commercial mechanism for a common commercial purpose, the question as to whether an arrangement has tax avoidance as its purpose or effect is to be approached in accordance with the Supreme Court's decision in Ben Nevis Forestry9 Income Tax Act 1994 ss BG1 and OB1; Income Tax Act 1976 s 9(1) and (2)Ventures v CIR.10 The Supreme Court held that specific tax provisions were to operate in tandem with the general anti-avoidance provision:[106] Put at the highest level of generality, a specific provision is designed to give the taxpayer a tax advantage if its use falls within its ordinary meaning. That would be a permissible tax advantage. The general provision is designed to avoid the fiscal effect of tax avoidance arrangements having a more than merely incidental purpose or effect of tax avoidance. Its function is to prevent uses of the specific provisions which fall outside their intended scope in the overall scheme of the Act. Such uses give rise to an impermissible tax advantage which the Commissioner may counteract. The general anti-avoidance provision and its associated reconstruction power provide explicit authority for the Commissioner and New Zealand courts to avoid what has been done and to reconstruct tax avoidance arrangements.[30] Determining whether the use of specific tax provisions amounts to tax avoidance therefore involves a two-stage inquiry. First, is the use made of the specific provision within its intended scope? If not, there is tax avoidance and the inquiry need go no further. But, if the use of the specific provision is within its intended scope, there may still be tax avoidance if: 11it is apparent that the taxpayer has used the specific provision, and thereby altered the incidence of income tax in a way which could not have been within the contemplation and purpose of Parliament when it enacted the provision.[31] It is clear from Ben Nevis that determination of this latter question may rest on a very broad range of considerations:[108] The general anti-avoidance provision does not confine the Court as to the matters which may be taken into account when considering whether a tax avoidance arrangement exists. Hence the Commissioner and the courts may address a number of relevant factors, the significance of which will depend on the particular facts. The manner in which the arrangement is carried out will often be an important consideration. So will the role of all relevant parties and any relationship they have with the taxpayer. The economic and commercial effect of documents and transactions may also be significant. Other features that may be relevant include the duration of the arrangement and the nature and extent of the financial consequences that it will have for the taxpayer. As indicated, it will often be the combination of various elements in the arrangement which are significant. A classic indicator of a use that is outside parliamentary contemplation is the structuring of an arrangement so that the taxpayer gains the benefit of the10 Ben Nevis Forestry Ventures v Commissioner of Inland Revenue [2008] NZSC 115; [2009] 2 NZLR 28911 Ben Nevis at [107]specific provision in an artificial or contrived way. It is not within Parliament's purpose for specific provisions to be used in that manner. [109] In considering these matters, the courts are not limited to purely legal considerations. They should also consider the use made of the specific provision in the light of the commercial reality and the economic effect of that use. The ultimate question is whether the impugned arrangement, viewed in a commercially and economically realistic way, makes use of the specific provision in a manner that is consistent with Parliament's purpose. If that is so, the arrangement will not, by reason of that use, be a tax avoidance arrangement. If the use of the specific provision is beyond parliamentary contemplation, its use in that way will result in the arrangement being a tax avoidance arrangement.[32] The Supreme Court's decision in Glenharrow Holdings Ltd v Commissioner of Inland Revenue is also of assistance. 12 Although the Court was considering the Goods & Services Tax Act 1985, its statements regarding the application of general anti-avoidance provisions are apt here. The Court particularly referred to the need for an objective assessment of whether an arrangement had been entered into so as to defeat the intent and application of the Act:[37] In Newton v Commissioner of Taxation of the Commonwealth of Australia,13 in giving the advice of the judicial committee, Lord Denning said that in the phrase "purpose or effect" in the Australian general anti- avoidance provision of that time the word "purpose" meant not motive but the effect which was sought to achieve – the end in view. The word "effect" meant the end accomplished or achieved. It was necessary, his Lordship said, to look at the arrangement itself and see its effect irrespective of the motives of the person who made it. [38] What Lord Denning was emphasising was that the general anti- avoidance provision was concerned not with the purpose of the parties, but with the purpose of the arrangement. That is a crucial distinction. Once you have put the purpose of the parties to one side and seek by objective examination to find the purpose of the arrangement, you must necessarily do that by considering the effect which the arrangement has had – what it has achieved – and then, by working backwards as it were from the effect, you are able to determine what objectively the arrangement must be taken to have had as its purpose. That approach is inevitable once any subjective purpose or motive is ruled out of contention, as the authorities say it must be. The position is summed up in a passage from the advice of the Privy Council in Ashton v Commissioner of Inland Revenue,14 where Viscount Dilhorne said: If an arrangement has a particular purpose, then that will be its intended effect. If it has a particular effect, then that will be its purpose and oral evidence to show that it has a different purpose or12 Glenharrow Holdings Ltd v Commissioner of Inland Revenue [2008] NZSC 116.13 Newton v Commissioner of Taxation of the Commonwealth of Australia [1958] AC 450 at 465 (PC).14 Ashton v Commissioner of Inland Revenue [1975] 2 NZLR 717 at 722 (PC).different effect to that which is shown by the arrangement itself is irrelevant to the determination of the question whether the arrangement has or purports to have the purpose or effect of in any way altering the incidence of income tax or relieving any person from his liability to pay income tax. This passage may at first sight appear somewhat circular but must be read as a whole. Viscount Dilhorne was clearly ruling out evidence of subjective purpose or motive and requiring the objective purpose to be determined from the effect of the arrangement. He went on immediately to approve what Lord Denning had also said in Newton:15In order to bring the arrangement within the section you must be able to predicate – by looking at the overt acts by which it was implemented – that it was implemented in that particular way so as to avoid tax. It is because the objective purpose is deduced from the effect that the phrase "purpose or effect" in general anti-avoidance provisions has been said to be a composite term.16[33] On the question of whether the purpose or affect of the arrangement was tax avoidance Mr Lennard argued, following the approach in Ben Nevis, first that the use of the relevant specific provisions were within their intended scope and, second, that the arrangement had a genuine commercial rationale.The specific provisions were used within their intended scope[34] Mr Lennard submitted that the true character of the advances was as loans which did not have income tax implications. He suggested that the TRA had fallen into error by viewing the advances as having to be either capital or revenue. At the commencement of the decision, when identifying the issue to be decided, the TRA stated that: 17Simply put, the issue is whether those loans were capital or income in the hand of the disputant.[35] Later, the issue was re-stated in a similar way: 18However, the issue is about the character of the disputant's drawings. Are they capital or assessable revenue? I have found that their character was15 Ashton at p 722 citing Newton at p 466.16 Tayles v Commissioner of Inland Revenue [1982] 2 NZLR 726 at 734 (CA).17 At [1].18 At [63].revenue as remuneration to the disputant for his personal exertions as the group entrepreneur and manager.[36] Mr Lennard submitted that by identifying the issue this way, the TRA failed to consider the principle that money is only received for income tax purposes when the recipient becomes definitively entitled to it. Since a loan, by its nature, must be repaid, the borrower never becomes definitively entitled to the funds. He relied on statements in the High Court of Australia's decision in Arthur Murray (NSW) Pty Ltd v Federal Commissioner of Taxation,19 where the Court reiterated observations made by Dixon J in Carden's Case (1938) 63 CLR 108:Speaking generally, in the assessment of income the object is to discover what gains have during the period of account come home to the taxpayer in a realised or immediately realisable form (1936) 63 CLR at p155. The word "gains" is not here used in the sense of the net profits of the business, for the topic under discussion is assessable income, that is to say gross income. But neither is it synonymous with "receipts". It refers to amounts which have not only been received but have "come home" to the taxpayer; and that must surely involve, if the word "income" is to convey the notion it expresses in the practical affairs of business life, not only that the amounts received are unaffected by legal restrictions, as by reason of a trust or charge in favour of the payer – not only that they have been received beneficially – but that the situation has been reached in which they may properly be counted as gains completely made, so that there is neither legal nor business unsoundness in regarding them without qualification as income derived. The ultimate inquiry in either kind of case, of course, must be whether that which has taken place, be it the earning or receipt, is enough by itself to satisfy the general understanding among practical business people of what constitutes a derivation of income. A conclusion as to what that understanding is may be assisted by considering standard accountancy methods, for they have been evolved in the business community for the very purpose of reflecting received opinions as to the sound view to take of particular kinds of items[37] An illustration of the concept of money not being definitively received can be found in the facts of A Taxpayer v CIR. 20 There, the Court of Appeal held that a person who had embezzled money was not liable to pay income tax on the amount because he had no claim of right to the money and was always liable to repay it. As a result, he had never held the money beneficially. This case would now be decided differently as a result of legislation aimed at taxing stolen money. 21 But Mr Lennard made the point that, leaving aside the amending legislation, there was no basis on19 Arthur Murray (NSW) Pty Ltd v Federal Commissioner of Taxation (1965) 114 CLR 314 (HCA).20 A Taxpayer v CIR (1997) 18 NZTC 13,350 (CA).which Mr Krukziener should be better off for tax purposes if he had simply stolen the money rather than borrowed and repaid it. [38] Mr Lennard also pointed out that income tax law generally follows commercial accounting principles.22 In a statement of financial position, a loan shown as an asset will have a corresponding liability represented by the obligation to repay. As a result, there is no gain as such for income tax purposes. [39] Mr Lennard is correct in his analysis of the nature of income and accounting treatment of loans. If the true character of the advances was a loan, then it would also be true that it had not been received by Mr Krukziener in the sense discussed. I did not, however, apprehend Mr Ebersohn to dispute that; rather, the Commissioner's case focused on the second aspect of the Ben Nevis enquiry, asserting that, regardless of any apparently legitimate use of specific provisions, the arrangement had as its purpose or effect the avoidance of tax. [40] Before considering the general avoidance provision, I consider two other points made by Mr Lennard. First, Mr Lennard said that as a corollary to the argument that the true nature of the advances was a loan, there is no principle that a proprietor of a business must take a salary. This is especially so in respect of businesses such as property investment and development. Mr Lennard relied, for this proposition, on Penny v CIR; Hooper v CIR.23 In Penny and Hooper, two orthopaedic surgeons, with substantial annual incomes, sold their practices to a company owned by their respective family trusts. They were then employed by the companies at salaries well below what they had previously earned, with the bulk of the income from their practice simply treated as company income and paid by way of shareholder dividend to the family trusts. The High Court held that the arrangement of the tax payer's affairs in this way was legitimate and did not constitute tax avoidance. In particular, the allocation of a commercially realistic salary was not required. 2421 Income Tax Act 1994, s CD622 e.g. Lowe v Commissioner of Inland Revenue [1981] 1 NZLR 326 (CA)23 Penny v Commissioner of Inland Revenue [2009] 3 NZLR 523 (HC); Hooper v Commissioner of Inland Revenue (2009) 24 NZTC 23,40624 Ibid[41] The High Court decision was appealed. Between the preparation of Mr Lennard's submissions and the hearing of this matter, the Court of Appeal released its decision. 25 The Court of Appeal considered that the restructuring of the taxpayer's practices was an arrangement that had both the effect of, and at least one of its purposes as, altering the incidence of income tax. The Court found the dramatic reduction in the taxpayers' respective incomes particularly significant. Although the Court was clear that its decision was not to be regarded as establishing any principle that salary levels in family companies below those to be expected in an arms length situation should necessarily be regarded, without more, as evidence of a tax avoidance arrangement, it did observe that:[126] It will be a matter of assessing all the circumstances including the extent and nature of any element of artificiality or contrivance in order to determine whether any particular arrangement is within or outside the contemplation of Parliament in enacting the tax legislation. Where there are legitimate reasons such as those discussed at [98] above for adopting a salary markedly below commercial levels, a challenge by the Commissioner may be unlikely to succeed. Nor would I expect the Commissioner to interfere in marginal circumstances. The difference here is that salaries were adopted at levels so far below ordinary commercial expectations that, in the absence of legitimate reasons for doing so, there is a strong implication of tax avoidance.[42] It may be that the proprietor of a property development business would, for the reasons that Mr Krukziener gave in evidence, be justified in accepting a salary below market or even no salary at all pending the completion of the project. So, in principle, Mr Lennard's submission stands, notwithstanding the Court of Appeal's decision. However, there is an obvious question on the facts of this case as to why Mr Krukziener would not have received any income over such a long period. This is a point that I consider later in relation to the assertion by Mr Krukziener that there was a genuine commercial rationale for the arrangement. [43] The next point was that the arrangement was consistent with the principle that income from trading trusts will be brought to tax either in the trust or in the hands of the beneficiaries to whom it is distributed. This is also correct. However, Mr Lennard's submission that Mr Krukziener did not account for, and pay tax on, distributions because there were no income profits to distribute, does not accord with25 Commissioner of Inland Revenue v Penny [2010] NZCA 231the evidence, as I discuss shortly, in relation to the commercial rationale for the arrangement.Did the arrangement have a more than merely incidental purpose or effect of avoidance of tax?[44] The case for the Commissioner, accepted by the TRA, was that the arrangement was only explicable by reason of the tax benefits flowing from it. Mr Lennard argued, however, that the arrangement involved loans which did have a genuine commercial basis. In setting the scene for this argument, Mr Lennard sought to characterise Mr Krukziener's arrangement as living off or borrowing against capital, which he portrayed as not uncommon. In support of this, he gave examples such as drawing down on a revolving credit facility secured by a residential mortgage to meet household expenses, increasing a home loan to pay for a holiday or selling a larger home to buy a smaller apartment and spending the balance on living expenses [45] Proceeding, then, on the basis that living off borrowings or borrowing against capital was not uncommon, Mr Lennard sought to demonstrate the commercial rationale for the arrangement. He pointed out, first, that the Commissioner did not assert that the advances to Mr Krukziener were shams. It is true that the Commissioner does not make that assertion in this case. However, the fact that the advances were genuine does not, in itself, demonstrate any commercial rationale for the terms of the advances since genuine loans can be consistent with a tax avoidance arrangement. [46] The second point made was that there were practical commercial reasons for not paying Mr Krukziener a salary during the life of the project. Allied to this point was the submission that there were no taxable profits available to distribute during the relevant period. It was asserted by Mr Krukziener and Mr Sheppard that there was, in fact, no income available to distribute to Mr Krukziener, that being the justification for borrowings in the expectation of either revenue profit or capital gain being distributed at some later time. However, as Mr Ebersohn pointed out, even on Mr Krukziener's and Mr Sheppard's own evidence, most of the developments and investments were profitable. The trustees (which were either Mr Krukziener aloneor included Mr Krukziener) simply elected to distribute the profit to a beneficiary other than Mr Krukziener, namely, another trading trust with losses that could be applied against the profit. [47] A significant theme in Mr Krukziener's case was that in terms of the distribution of profit, he was building towards the Metropolis project:At a certain point you stop, you know, let's assume you do five projects you get to project five and at the end of that you have a whopping great tax bill in that project and then you pay tax. That's where I was actually heading to but then unfortunately I lost a huge amount of money which basically wiped out everything that I had built up before I was hoping one day to have a massive tax bill when effectively we got to the appropriate point.[48] As I have already noted, evidence of subjective beliefs and intentions is not relevant in terms of assessing the existence of an arrangement. In any event, I would place little weight on Mr Krukziener's assertions that repayment of the current accounts, or indeed payment of tax, was intended to come from the Metropolis project. The Metropolis project post-dated the advances from the Felix Trust and was, in fact, the cause of Mr Sheppard ceasing his involvement with Mr Krukziener, including as a trustee of the Felix Trust. By the time the Metropolis project was underway, advances from the Felix Trust had already been outstanding for several years so I cannot place weight on an assertion that throughout the relevant period, Mr Krukziener was working towards that project as an end point in terms of distribution of profit, repayment of current accounts and payment of tax. [49] Further, even if the plan had been to take the profit from the Metropolis development and use it to pay tax, the fact that both repayments and tax had been deferred for so many years would, in itself, have the effect of tax avoidance. Where the proprietor of a business has expended time and effort on a project, and incurred debt waiting for the project to be completed, and the project is completed at a profit, there would seem to be no legitimate reason for some of that profit not to be distributed. The need of the next project for funds does not preclude such distribution since it is always open to the proprietor of the business to advance funds for the next project. In the circumstances of this case, therefore, I do not accept thatthe level of income provided to Mr Krukziener over such a long period can be regarded as legitimate. [50] Mr Lennard also relied on Mr Sheppard's evidence that making distributions from profit was not necessarily desirable:In the context of property developers and in my experience of them [allocating capital to a beneficiary]...is a very unwise thing to do because inevitably they always trade beyond their ability to adequately capitalise themselves. I characterise them as roulette players that forget to take their winnings off the table The best defensive strategy you can adopt for such clients and tax payers is to leave them in debt to themselves. I thus would have been exceedingly concerned to have allocated an income while he had continuing high-profile, high-risk projects. When things calm down and they either do or they don't, they either get to their maker naked or dressed, if they get to their maker dressed you clean it up at that point when their risks are dealt with. So it's entirely appropriate to make advances, record them as debt and expect them to be repaid. It's part of a sensible risk management strategy for people who are very high risk takers.[51] This evidence did identify a commercial rationale for not allocating income to Mr Krukziener; namely leaving him in debt as a defensive strategy. However, I do not place much weight on this rationale for two reasons. The first is that, if the reason for not allocating capital or income to Mr Krukziener was as a protection in the event of failure, the AK360 distribution, at the very time when Mr Krukziener was facing financial difficulty, was inconsistent with that rationale. Secondly, there were significant disadvantages to Mr Krukziener in this course; the funds (on his own evidence) were liable to be repaid eventually and, receipt of loans, as opposed to income from the group, exposed Mr Krukziener to personal liability in the event of a liquidation, defeating the purpose of operating through a limited liability company such as KPL. [52] Looking also at the interests of the group generally, it can be seen that the funding of Mr Krukziener's advances came from external funding on which interest was paid at commercial rates. A long-term arrangement under which a trust or company borrows externally at commercial rates to lend to a beneficiary or shareholder interest-free has no apparent commercial rationale. This is all the more so when the entities or associated entities have profit that might be distributed to the beneficiary/shareholder but choose not to do so.[53] This brings me to Mr Lennard's argument that the TRA had attributed significance to the way in which the capital profit, used to repay the KPL advances, had been distributed. The TRA regarded that distribution and use of it to repay the current account as offensively circular:[56] Most repayments were by journal entry. If any trust obtained a capital benefit this could be distributed to the disputant by journal entry and immediately utilised by him again, by journal entry, in repayment of a loan [62] I am conscious that at least one trust made capital profits over the relevant years. That particular trust seemed to have acquired a property for leasing purposes but, some years later, due to financial pressure from the failed project, sold it for significant capital profit ($4.6m I understood but that may have been the sale price rather than the profit). That could have been distributed to the disputant as capital profit. There were book entries purporting, to do that but in reality, the funding was circular and all remained in the disputant's group.[54] Mr Lennard had two objections to the TRA's approach to this distribution and subsequent repayment. The first was that, whilst there was some circularity about it, it involved entirely legitimate transactions in the form of a genuine distribution of capital gain, and the use of that money to discharge real obligations. The fact that the distribution and repayment were effected by journal entry had no effect on the true nature of them. I accept this submission. How a distribution is made, whether by payment of cash or allocating income through a journal entry is not significant; it is the fact of distribution that is the issue. Nor do I see the circularity of the payments as significant. Self-evidently, a proprietor whose only source of income is his business can only repay current account debts from income or profit distributed by that business. [55] The second criticism Mr Lennard had for this aspect of the decision is that it was impossible to predict, at the time the current account borrowings were drawn down, that they would be repaid through this particular distribution. The capital gain was unexpected in the sense that the decision to sell the property concerned was only made in response to the failure of the Metropolis development and was therefore unknown and unforeseeable at the time the borrowings were drawn down. However, the significance of the repayment lay in this very fact. Many years had passedwithout any significant repayments being made and the use of the AK360 distribution to repay KPL simply reinforced the fact that the repayments were not made unless and until there was a non-taxable distribution to make them from. [56] Further, as the TRA noted, although Mr Krukziener was theoretically required to repay them that could only really happen either through the group making further loans or awaiting opportunities for non-taxable capital distributions. Since Mr Krukziener controlled such distributions, repayment of the current account debt was effectively at his discretion. [57] In contrast, the Commissioner's argument against the existence of a genuine commercial rationale was compelling. It was apparent that during the period that Mr Krukziener owed the Felix Trust, KPL and other entities money under his current accounts, the group was funded by external borrowings. These borrowings attracted interest at commercial rates. Notwithstanding the fact the group was meeting the cost of external borrowing at a time when Mr Krukziener owed it substantial money, there was no demand for repayment. Nor was interest required to be paid until 2001. Even that is to be viewed with a degree of scepticism because Mr Ebersohn pointed out that Mr Krukziener had been advised in October 1999 that his personal tax affairs were being reviewed. [58] Against these various disadvantages, the tax benefits of the arrangement stand out clearly. Notwithstanding the asserted rationale, the effect of the arrangement was clearly tax avoidance, at least in the sense of deferring the tax obligation. Over more than a decade during which more than 80, mostly profitable, projects were completed under Mr Krukziener's stewardship, he received more than $5 million nett to cover his living expenses on which no tax was paid. He repaid most of that from capital receipts on which no tax was payable and the balance has never been repaid. Nor was interest paid until 2001, by which time Mr Krukziener was aware that his tax affairs were to be investigated. Looking at the overall benefits of the arrangements to Mr Krukziener, it is apparent that the protection offered by the debt had much less effect in commercial terms than the deferment or avoidance of income tax.Time bar – s 108 of the Tax Administration Act 1994[59] Under s 108(1) of the Tax Administration Act 1994, the Commissioner cannot amend an assessment after four years from the end of the income year in which the return is filed:108 Time bar for amendment of income tax assessment(1) Except as specified in the section or in s 108B, if – (a) A taxpayer furnishes an income tax return and an assessment has been made; and (b) Four years have passed from the end of the tax year in which the taxpayer provides the return – the Commissioner may not amend the assessment so as to increase the amount assessed[60] However, there are exceptions to this in s 108(2) including if the taxpayer has omitted to mention income of a particular nature or derived from a particular source in the tax return:(2) If the Commissioner is of the opinion that a tax return provided by a taxpayer – (a) Is fraudulent or wilfully misleading; or (b) Does not mention income which is of a particular nature or was derived from a particular source, and in respect of which a tax return is required to be provided – the Commissioner may amend the assessment at any time so as to increase its amount.[61] Section 108 applies to the assessments made in the years 1997 to 2000. During these years, loans were made predominantly by KPL. In tax returns filed for those years, Mr Krukziener returned shareholder salary from KPL. He asserts that because he referred to salary income from KPL in those returns and the Commissioner's reconstruction treats the loans as salary from KPL, the income that was declared was of the same nature as the income returned or income from the same source. As a result, Mr Krukziener maintains that the time bar under s 108(1) applies to these years.[62] The TRA rejected this argument. At [105] of its decision, the TRA citedCross v CIR26 and the statement by Somers J to the effect that the exception does not require the taxpayer to return an amount as income if he or she asserts that it is not income. It must nevertheless be mentioned for the exception not to apply: 27It would be an unreasonable construction of s 24(2) to hold that it requires the taxpayer to return that as income which he asserts is not income. If, however, he omits all mention of the gain which subsequently is found to be assessable income, s 24(2) will apply. The subsection is not directed to a failure to characterise the advantage as income but the failure to mention it at all. It is the latter omission which enables an amended assessment to be made after the four-year period has expired.[63] In the same case, Richardson J explained the purpose behind the section: 28It is sufficient if there is mention of such income and "income", not itself a defined term, is clearly used in that context in a very general sense. Obviously the subsection does not require a taxpayer to report items as assessable income in order to obtain any protection under s 24(1). The mischief at which the subsection is directed is the withholding of information from the Commissioner It is sufficient to draw the item to the Commissioner's attention in the returns filed.[64] Mr Lennard accepted that Cross was correct insofar as the first limb of the test in s 108 was concerned. He focused on the second limb which relates, not to income of particular nature, but "incomederived from a particular source". He argued that Mr Krukziener had referred, in his tax return for the relevant years, to income from KPL and therefore had satisfied s 108(2)(b). However, this argument does not survive the statements of the Privy Council in Miller v CIR.29 There, the taxpayers argued that their returns had not altogether omitted mention of income of the nature or from the source in respect of which they were being assessed because they had included various sums paid by way of remuneration and the Commissioner's reconstruction had treated other money received as if it were remuneration. Therefore, they argued, it was income of a nature and from a source that had been disclosed. The Privy Council rejected this argument:[22] Their Lordships consider that this argument is based upon a misapprehension about the effect of a reconstruction. The Commissioner's26 Cross v CIR [1987] 9 NZTC 6,101 at 6,111 (CA); [1987] 1 NZLR 498 at 50827 Cross v CIR [1987] 9 NZTC 6,101 at 6,111 (CA); [1987] 1 NZLR 498 at 50828 At 6,107; at 50329 Miller v Commissioner of Inland Revenue [2001] 3 NZLR 316 (PC)duty is to make an assessment with regard to what in his opinion was likely to have happened if there had been no scheme. But that does not mean that he is actually rewriting history. The reconstruction is purely hypothetical and provides a yardstick for the assessment. Although the income is deemed to have been derived by the person assessedthe nature and source of the income remains what it was, namely the company's net profits routed to the shareholders through Mr Russell's company. None of this was disclosed.[65] In the present case the money that is the subject of the enquiry is the advances made by the various entities through Mr Krukziener's current accounts. No mention was made of this money in Mr Krukziener's tax returns. As a result, it cannot be argued that there was any reference either to its nature or its source.Tax avoidance penalties[66] The TRA held that, in relation to the income years ended 1998-2002, Mr Krukziener was liable for penalties under s 141D of the Tax Administration Act 1994 for taking an abusive tax position. [67] Under s 141D, a taxpayer will be liable for an abusive tax position penalty if: a) He or she took an unacceptable tax position; and b) Viewed objectively, the taxpayer took that position in respect of or as a consequence of an arrangement entered into with the dominant purpose of avoiding tax; and c) The resultant tax shortfall was more than $20,000. [68] The expression "unacceptable tax position" is defined by s 141B which relevantly provides:(1) A taxpayer takes an unacceptable tax position if, viewed objectively, the tax position fails to meet the standard of being about as likely as not to be correct[69] This definition was considered in Ben Nevis, with the Supreme Court concluding that:30[184] On its terms this standard does not require that the appellants' tax position had a 50 per cent prospect of success but, subject to that qualification, the merits of the arguments supporting the taxpayer's interpretation must be substantial. The stipulation of an objective test means that the taxpayer's belief that the position taken was correct, or not acceptable, is irrelevant.[70] The TRA held that:[125] The disputant's tax position was incorrect as it infringed s BG1 of the Act. It seems to me that the disputant's arguments lack merit. The disputant entered into the arrangement with the dominant purpose of avoiding tax. I have already noted that: the arrangement could not be explained by any commercial purpose; and the only objective purpose was to avoid tax (and tax was avoided).[71] Mr Lennard argued that Mr Krukziener's interpretation as to the tax position could not be said to be unacceptable in the sense of failing to meet this standard but was a tenable position and reflected orthodox standards of interpretation of the anti- avoidance provision. I do not accept that argument. For the reasons already canvassed, the tax benefits to Mr Krukziener stand out as being the dominant purpose of this arrangement. I do not exclude the evidence of other reasons. But those reasons alone do not account for this longstanding arrangement that enabled Mr Krukziener and the group to avoid paying tax for more than a decade. I consider that the TRA's conclusion on this point was right. [72] Mr Lennard's final argument on this issue was that any shortfall resulting from the position taken by Mr Krukziener should be offset against deductions allowed to entities making the advances and that such deductions would reduce or extinguish the amount of the shortfall. Mr Lennard made his submission in reliance on s 141(7) of the Tax Administration Act 1994 which permits the adjustment I have just referred to. However, he did not refer to s 141(7B) which provides that the Commissioner may exercise the discretion under s 141(7) to reduce a taxpayer's shortfall through an adjustment for associated persons if:30 Ben Nevis Forestry Ventures v Commissioner of Inland Revenue [2008] NZSC 115; [2009] 2 NZLR 289 at [184](c) The taxpayer's tax position is not an abusive tax position and does not involve evasion or a similar act.[73] Self-evidently, Mr Krukziener's situation falls within s 141(7B)(c). An adjustment of the kind proposed is therefore not available.Result[74] The appeal is dismissed. [75] I was not addressed on the issue of costs. Counsel may file memoranda on behalf of the Commissioner within 14 days, on behalf of Mr Krukziener within 21 days and on behalf of the Commissioner in reply, within 28 days. ____________________ P Courtney J