COMMISSIONER OF INLAND REVENUE V IAN DAVID PENNY AND GARY JOHN HOOPER CA CA201/2009

COMMISSIONER OF INLAND REVENUE V IAN DAVID PENNY AND GARY JOHN HOOPER CA CA201/2009 4 June 2010IN THE COURT OF APPEAL OF NEW ZEALAND CA201/2009 [2010] NZCA 231BETWEEN COMMISSIONER OF INLAND REVENUE Appellant AND IAN DAVID PENNY AND GARY JOHN HOOPER Respondents Hearing: 9 and 10 February 2010 Court: Hammond, Ellen France and Randerson JJ Counsel: D J Goddard QC, H W Ebersohn, M Burr for Appellant G J Harley and C E Bibbey for Respondents Judgment: 4 June 2010 at 2.15 pmJUDGMENT OF THE COURT A The appeal is allowed. B The arrangements identified by the appellant in respect of the income tax years 2002, 2003 and 2004 are declared to be void against the appellant for income tax purposes in terms of s BG 1 of the Income Tax Act 1994. C Leave to apply is reserved if any consequential issues arise. D The appellant is entitled to costs against the respondents jointly and severally for a complex appeal on a band A basis and usual disbursements.E The appellant is entitled to costs in the High Court as agreed or fixed by that Court.REASONSRanderson J [1] Hammond J [132] Ellen France J (dissenting) [163]RANDERSON JTable of ContentsPara NoIntroduction [1]Background facts [7]Mr Hooper [8]Mr Penny [20]Mr Lyne's evidence as to salary [38]The approximate amount of the tax the Commissioner says has been avoided [41]The decision under appeal [44]The relevant statutory provisions [61]The Supreme Court's decision in Ben Nevis [62]The Glenharrow decision [66]The nature and scope of the arrangement alleged [70]Did the "arrangement" directly or indirectly have tax avoidance as one of its purposes or effects? [86]The significance of the Hadlee case [101]Conclusions [110]Result [129]Introduction[1] In this appeal, the Commissioner of Inland Revenue alleges tax avoidance by the respondents who practise as orthopaedic surgeons. Initially they each conducted their practice on their own account. Later, each set up a company to purchase their practice. The companies are owned substantially by the respondents' family trusts. Thereafter, each respondent was employed by their respective companies at a salary the Commissioner considers to be artificially low. The balance of the practiceincome in each case was treated as company income and paid by way of shareholder dividend to the family trusts. [2] The Commissioner formed the view that the restructuring of the respondents' practices and the allocation of such low salaries was an arrangement which had the purpose or effect of tax avoidance in terms of s BG 1 of the Income Tax Act 1994 ("the Act"). In particular, the Commissioner considered the respondents improperly took advantage of the lower company tax rate of 33 cents in the dollar and should have been taxed at the higher marginal tax rate of 39 cents in the dollar applicable to their personal income. The Commissioner's view was that the difference of six cents in the dollar between the company and personal tax rates was avoided to the extent that the salaries allocated to the respondents were set at commercially unrealistic levels. [3] The Commissioner reassessed the respondents' income for the tax years 2002 to 2004 by attributing salaries to each of them at a substantially higher level. He did so on the basis of advice as to what level of salary would be commercially realistic in the circumstances. [4] After following the statutory processes for tax disputes, the matter reached the High Court. MacKenzie J accepted the respondents' case that the formal structures adopted by the respondents were a legitimate choice for the conduct of their businesses. 1 He also found that the way in which they conducted their affairs did not constitute tax avoidance. In particular, he found that the arrangement was not contrary to the scheme and purpose of the Act and that the allocation of a commercially realistic salary was not a concept recognised by the Act. [5] The central issue in this appeal is whether MacKenzie J was right to conclude that the respondents' activities did not constitute a tax avoidance arrangement. In addition, there are two subsidiary issues in relation to the scope of admissible evidence.1 Penny v Commissioner of Inland Revenue [2009] 3 NZLR 523.[6] In advancing the appeal for the Commissioner, Mr Goddard QC's principal ground of appeal is that the Judge failed to address the Commissioner's contention that the arrangement was contrived and artificial. For the respondents, Mr Harley supported the High Court's decision substantially for the reasons given by the Judge.Background facts[7] I am indebted to MacKenzie J for his careful outline of the facts which are largely undisputed. I will deal with each of the two surgeons in turn.Mr Hooper[8] Mr Hooper has practised as a specialist orthopaedic surgeon in Christchurch since 1985. Initially he was employed on a salaried basis by the Canterbury District Health Board, but from 1989 he began to practise in the private sector as well, joining a group of specialists in an orthopaedic centre. Each of the surgeons operating from the centre conducted their own separate practices but shared staff, equipment and facilities under arrangements governed by a deed of management. [9] In 1991, Mr Hooper and his wife each settled family trusts which the Judge described as "mirror trusts". In each case the trustees were their solicitor and accountant. The beneficiaries of each trust were the spouse, children and grandchildren. The trusts were established to purchase a half share each of Mr Hooper's interest in the premises occupied by the orthopaedic centre. [10] From 2000, the practice arrangements were restructured. A new company called Hooper Orthopaedic Limited ("HOL") was formed with 1,000 shares. The family trusts owned all the shares except ten which were held equally by Mr Hooper and his wife. Mr Hooper was the sole director. His orthopaedic practice was sold to the company for $332,473. Almost all of this sum ($300,000) was for goodwill. HOL assumed Mr Hooper's obligations in respect of the orthopaedic centre. Mr Hooper continued to practise in the same way as before, but his private orthopaedic work was conducted as a salaried employee of HOL.[11] He continued after the restructuring with his private patients and maintained his commitment to work for the District Health Board. It is common ground that, despite the fact that all private patient referrals have been to Mr Hooper personally, his earnings from these sources are properly attributable to HOL. [12] With effect from 1 April 2000, the top marginal tax rate on personal income was increased from 33 per cent to 39 per cent. I consider it is no coincidence that the restructuring of Mr Hooper's practice occurred in 2000. The restructuring resulted in a dramatic difference in Mr Hooper's personal income demonstrated by the following table produced in evidence by an investigative accountant called by the Commissioner, Mr Brendan Lyne:HOL – summarised normalised financial performance (1999-2004)Year ended 31 March 1999 Sole $'000 2000 Sole $'000 2001 HOL $'000 2002 HOL $'000 2003 HOL $'000 2004 HOL $'000 IncomeFees received 1,176 1,119 1,238 1,098 1,197 9681,176 1,119 1,238 1,098 1,197 968 ExpensesDepreciation Surgical supplies Insurance Motor vehicle expenses Rent Wages Other expenses (21) (300) (8) (3) (90) (63) (32) (21) (275) (8) (1) (71) (62) (30) (9) (297) (8) (10) (74) (202) (46) (10) (283) (8) (9) (84) (203) (54) (7) (343) (9) (8) (84) (203) (43) (6) (172) (7) (9) (84) (203) (51)(517) (468) (646) (651) (697) (532) EBITAdd back wage to Mr Hooper65906510592120447120500120436120EBITP 659 651 712 567 620 556[13] This table demonstrates that Mr Hooper's pre-tax income after expenses dropped from around $650,000 in the 1999 and 2000 years to a round figure of $120,000 per annum for the years 2001 to 2004. Despite the fact that Mr Hooper continued to work exactly as before, his personal earnings from the practice dropped to slightly under 18 per cent of his income before the restructuring. All of the practice income resulted from Mr Hooper's personal exertions. [14] The income derived from fees paid by patients constituted income of the company which, after deduction of expenses (including Mr Hooper's salary) was returned as the company income. Tax was paid at the company rate of 33 cents inthe dollar on this income in the years at issue. The family trusts received fully imputed dividends from the company. A portion of the income received by the trust was distributed to Mr Hooper's daughters and taxed as their income. The remainder was retained by the trusts as trustee income. [15] In each of the years 2001, 2002 and 2003, Mr Hooper returned his salary from the company at $120,000 (rounded) but in the 2004 year he returned a salary of $420,297. He explained in evidence that this was a precaution in order to avoid the imposition of shortfall penalties should the Commissioner succeed in supporting his reassessment of income. In that year the actual salary remained at $120,000. In addition, in the years 2001 to 2004, Mr Hooper returned as personal income his salary from the District Health Board which ranged, in those years, from $79,000 to $104,000 (again with rounded figures). [16] The retained earnings have been primarily invested by the trusts in cash and bank deposits, the Hooper family home and a holiday home. Mr and Mrs Hooper have not personally received any payments from the trusts, nor have they borrowed funds from that source. [17] Mr Hooper deposed that, in the late 1990s, he had become concerned about the possibility of exposure to medical negligence claims and was aware that a number of surgeons had set up or transferred their practices to companies or trading trusts. At about the same time he was considering options for the family trust to invest outside essentially passive investments and to generate more income for potential distribution, particularly to his children as beneficiaries as they began university. The company structure was adopted after discussion by him with his accountant. He acknowledged he was aware that the personal tax rate was to change from 1 April 2000. A goodwill figure of $300,000 was agreed upon after discussions with his colleagues and with his accountant. The purchase by HOL was funded by way of an advance from Mr Hooper which remains outstanding. [18] As to the level of salary, Mr Hooper's evidence was that he made the decision as the sole director of HOL. He did so after speaking to colleagues, the clinical director of orthopaedic surgery at Christchurch Public Hospital and with hisaccountant. He was advised by colleagues that a salary commensurate with the public hospital salary was a common benchmark. The level adopted of $120,000 was, he said, about 1.4 times his salary with the District Health Board. [19] In cross-examination, Mr Hooper readily accepted that he would not have accepted a salary of $120,000 if employed by an independent company. To do so would, he admitted, be "commercially silly".Mr Penny[20] In broad outline, Mr Penny restructured his practice in a similar way to Mr Hooper's but he did so in 1997, several years before the increase in the top personal tax rate. At the time of the incorporation of his practice, the top personal tax rate was the same as the corporate rate. [21] Mr Penny commenced practice as a specialist orthopaedic surgeon in 1989. He worked initially for the Canterbury District Health Board but, in 1991, commenced private practice. Until 1997, he practised on his own account but in that year he incorporated two companies. The first was Penny Orthopaedic Services ("POS") in which he was the sole shareholder. The second was Orthopaedic Surgical Consultancy Limited ("OSCL") which was wholly owned by the AC Penny No 1 Trust established at the same time. The trustees were Mr Penny's accountant (the same accountant as Mr Hooper's) and two of Mr Penny's solicitors. The final beneficiaries were himself, his wife, their children and grandchildren. [22] The premises in which the practice was conducted, which had been owned to that point by Mr Penny, were leased by him to POS and then sold to the trust for $330,700. Almost all of this sum was attributed to the land and buildings. Mr Penny's orthopaedic practice was transferred to POS in 1997 for $144,310, including $100,000 for goodwill. He then entered into an employment contract with POS which provided that his salary would be paid at a figure to be agreed upon from time to time. The term of employment was for ten years with Mr Penny undertaking he would not in that period work for anyone else other than the District Health Board.[23] Two months after POS had purchased his practice, it was on-sold to OSCL for $1,044,310. The purchase price comprised $1 million for goodwill, $43,810 for plant and fittings and $500 for stock-in-trade. OSCL borrowed in order to meet the purchase price. These transactions enabled Mr Penny to receive a capital dividend from POS of $900,000 which he used to repay personal debt. POS was later removed from the register of companies. [24] Mr Penny understood that his contract with POS would be assigned to OSCL, but there has been no written assignment. Nor is there any written contract of employment between OSCL and himself. [25] After the restructuring, Mr Penny continued to practise exactly as before with a similar number of patients. As in Mr Hooper's case, Mr Penny received referrals on a personal basis, but it is not in dispute that the earnings from his private patients were properly attributable to OSCL. [26] The following table prepared by Mr Lyne shows the earnings of OSCL and the salary allocated to Mr Penny over the period 1999 to 2004:OSCL – Summarised earnings before interest and taxation (1999-2004)Year ended 31 March 1999 $'000 2000 $'000 2001 $'000 2002 $'000 2003 $'000 2004 $'000 IncomeFees received Rent received 1,349 11 1,113 11 1,140 11 1,346 11 1,175 11 1,155 111,360 1,124 1,151 1,357 1,186 1,166 ExpensesDepreciation Surgical supplies Insurance Motor vehicle expenses Rent Wages Other expenses (22) (242) (1) (11) (38) (446) (88)) (34) (185) (1) (11) (38) (271) (87) (31) (215) (1) (17) (38) (205) (106) (30) (246) (2) (14) (38) (206) (103) (26) (181) (2) (14) (38) (192) (76) (27) (165) (5) (12) (38) (204) (103)(848) (627) (613) (639) (529) (554) EBITAdd back Mr Penny's salary and benefits received from OSCL: Wages Motor vehicle benefits512302 11497125 11538100 17718100 14657100 14612100 12313 136 117 114 114 112 EBITP 825 633 655 832 771 724[27] There are two features of significance from this summary. First, from 2000 onwards, a much lower salary than previously was allocated to Mr Penny. Itdropped from $302,000 in 1999 to $125,000 in 2000 and stayed steady at $100,000 thereafter. To be fair to Mr Penny, he explained that the 1999 year was exceptionally profitable. Using rounded amounts, the figure of $302,000 in 1999 included salary of $260,000 plus a director's bonus of $42,000. In the previous year (1998), the net earnings of OSCL before tax had been lower at $300,000 and his salary, including a bonus, was $184,000. Nevertheless there was a marked drop in the salary level from the year 2000 onwards and no bonuses were paid to Mr Penny thereafter. Again, it is no coincidence that the salary (essentially fixed by Mr Penny in conjunction with his accountant) was significantly reduced immediately prior to the commencement of the 39 per cent personal tax rate. [28] I should add that, although the salary actually paid to Mr Penny in the 2004 year was $100,000, he returned income for that year of $485,235 for tax purposes for the same reason as Mr Hooper, namely as a precaution in the event of shortfall penalties being imposed during the tax reassessment process. [29] The second significant feature of this summary is the comparison of the net earnings of the company (before tax and interest) with Mr Penny's salary. In the disputed tax years, the company's net earnings before tax ranged from $612,000 to $718,000 while Mr Penny's personal salary was maintained at $100,000 per annum. His salary represented about 16 per cent of the company's net earnings in the 2004 year and an even lower percentage in the 2002 and 2003 years. This notwithstanding that the company's earnings were all due to his own personal exertions. His salary in the disputed tax years dropped to about one-third of the 1999 level. [30] In cross-examination, Mr Penny accepted that the salary paid to him by OSCL was not commercially realistic and that he would not have entered into that arrangement with an unrelated party. He cited similar reasons to those advanced by Mr Hooper for adopting the company/trust structure. He too had become concerned about exposure to litigation not covered by Accident Compensation and was concerned with adopting a structure which would offer the best asset protection. He took advice from his accountant and solicitor and others before deciding to restructure.[31] OSCL paid tax at the company rate on its earnings. The A C Penny No 1 Trust, as sole shareholder in OSCL, received fully imputed dividends from the company in each year. These were: 2001 $133,064 2002 $1,175,545 2003 $348,400 2004 $348,400 [32] In turn, the trust advanced the following sums to Mr Penny on an unsecured, interest-free basis with no term specified for repayment: Balance as at 1 April 2001 $(21,831) Balance as at 1 April 2002 $(627,318) Balance as at 1 April 2003 $(820,961) Balance as at 1 April 2004 $(1,236,350) [33] Mr Penny explained that most of the borrowings were needed to pay a specific obligation which he identified. Some was also borrowed for tuition expenses for the children and maintenance payments. [34] Mr Lyne's evidence was that the dividends paid to the trust effectively represented the OSCL profits for the 2002 to 2004 income years, together with profits generated in previous years. The net movement in the total equity/net assets of OSCL was a decrease of $730,000 over the 2002 to 2004 income years from $777,000 to $46,000. In the same period, the net assets of the trust increased by $1.81 million from $323,000 to $2.133 million. However, 94 per cent of the net increase in the trust's assets represented the advances made to Mr Penny and other advances made to OSCL. [35] Mr Lyne's conclusion, as stated in his written brief, was:135. In my opinion, the above transactions demonstrate that the No 1 Trust over the 2002 to 2004 income years was used primarily as a conduit for the transfer of funds from OSCL to Mr Penny, on a no interest basis andwith no specified payment terms. Mr Penny had effective control over these funds, in the same manner as if he were a sole trader and the proceeds from his practice were his personal income, to deal with as he thought fit.[36] Mr Lyne was critical of the way in which Mr Penny drew on company funds for personal use, but he accepted in cross-examination that it was not unusual for a director to draw funds for personal use directly from the company bank account, subject to an appropriate accounting entry to record the cash movements in due course. Nevertheless, it remains the case that Mr Penny had direct control over OSCL's bank account for his own purposes. In practice, the trust did not have access to the funds he drew from the company. [37] Mr Goddard placed considerable reliance on Mr Penny's private use of OSCL's funds and submitted it could properly be regarded as part of the "arrangement" for the purposes of s BG1. Alternatively, he submitted that, at the least, it was evidence to support the Commissioner's contention that the adoption of an unrealistically low salary within the business structure was an artificial and contrived device. I return to this issue later.Mr Lyne's evidence as to salary[38] Since it is accepted that the salaries paid to the respondents were not commercially realistic if they had been independently employed, it is unnecessary to dwell on Mr Lyne's evidence in detail. In summary, he concluded that a commercially realistic salary for Mr Hooper for the 1999 to 2004 income years was in the range of $460,000 to $616,000. The midpoint of that range is $538,000. This compares with his actual salary in the disputed income years of $120,000. [39] Mr Lyne assessed a commercially realistic salary for Mr Penny for the 1999 to 2004 financial years in the range of $533,000 to $732,000. The midpoint of that range is $633,000. This compares with the actual salary allocated to Mr Penny in the disputed income years of $100,000.[40] Although the Judge was critical of some aspects of the methodology adopted by Mr Lyne, the respondents do not challenge Mr Lyne's assessment of what would constitute a commercially realistic salary.The approximate amount of the tax the Commissioner says has been avoided[41] The Commissioner issued notices of proposed adjustment for the relevant income years. The broad effect of the adjustment in each case was to increase the respondents' taxable income by an amount equal to the difference between the salary paid to them by their companies and the amount the Commissioner assessed as a commercially realistic salary. Although the figures were not before us, the Commissioner's assessment will necessarily result in a consequential adjustment to the income of the companies for tax purposes to reflect the additional salary assessed for the respondents. [42] Mr Goddard supplied the following summary of the estimated tax savings, adopting Mr Lyne's midpoint figures for the appropriate salaries:Year HOL earnings (EBITP) Hooper salary paid Annual CRS Midpoint CRS Tax saving 000's2002 567 120 471 538 21.1 2003 620 120 524 538 24.2 2004 556 120 460 538 20.4Year HOL earnings (EBITP) Penny salary paid Annual CRS Midpoint CRS Tax saving 000's2002 832 100 732 633 37.9 2003 771 100 671 633 34.3 2004 724 100 624 633 31.4[43] In summary, in the Commissioner's assessment, the approximate tax savings are about $65,000 in Mr Hooper's case and $103,000 for Mr Penny. These figures differ slightly from those referred to at [10] of MacKenzie J's judgment but the difference is not material for present purposes.The decision under appeal[44] The case in the High Court was argued prior to the delivery of the Supreme Court's decisions in Ben Nevis Forestry Ventures Ltd v Commissioner of Inland Revenue2 and Glenharrow Holdings Ltd v Commissioner of Inland Revenue.3However, these decisions were available prior to MacKenzie J's judgment and he rightly focussed on the principles established in those decisions as the most recent and authoritative statements in this field. [45] The Judge set out the relevant statutory provisions and then analysed the nature and implications of the alleged tax avoidance arrangement under three headings: (a) the formation of the companies; (b) the fixing of the salaries; and (c) the implications in Mr Penny's case of the cashflows and loans made to him personally through the trust. [46] Under the first heading, the Judge emphasised the undoubted proposition that the conduct of a business through a company owned by a family trust is a valid choice of business structure in commercial terms. Similarly, he accepted that the separate legal identity of a company and the individuals who control it are well established under the general law. Mr Goddard does not challenge those propositions. [47] The Judge correctly observed that, on a literal reading of s BG1 of the Act, the formation of the companies and the conduct of the practice of the respondents through those companies had the effect of altering the incidence of tax. That followed from the differing rates of tax applicable to companies and individuals and2 Ben Nevis Forestry Ventures Ltd v Commissioner of Inland Revenue [2008] NZSC 115, [2009] 2 NZLR 289.3 Glenharrow Holdings Ltd v Commissioner of Inland Revenue [2008] NZSC 16, [2009] 2 NZLR 359.the graduated scale of personal income tax which has long been an established feature of New Zealand tax legislation. [48] The Judge correctly recognised that, on the scheme and purpose approach to the interpretation of the anti-avoidance provisions mandated by the Supreme Court, that alteration was not, of itself, sufficient to bring the case within the definition of tax avoidance. 4[49] Mr Goddard relied in the High Court and before us on the well known case ofHadlee v Commissioner of Inland Revenue.5 He contended that Hadlee established that an arrangement such as that adopted by the respondents was not contemplated by the scheme and purpose of the Act. The Judge rejected that proposition, distinguishing Hadlee on the footing that the Court was concerned there with the assignment of income whereas the case at hand was concerned with the derivation of income. In tax terms, the Judge considered the two concepts to be quite different. [50] The Judge went on to consider the relevance of the Personal Services Attribution ("PSA") Rules GC14B – 14E which were introduced at the same time as the increase in the top personal tax rate from 1 April 2000. The PSA Rules apply where a company, trust or partnership is interposed between an employer or an individual who provides personal services. A key feature is that the rules apply where the company (or other entity) derives 80 per cent or more of its earnings from a single source. I agree with the Judge that the PSA Rules are directed at situations where the company does not have a genuinely independent business and the relationship with the income provider is akin to one of employment. [51] It is common ground that the respondents are not caught by the PSA Rules since the income of the respective companies is derived from a large number of individual patients and does not reach the 80 per cent threshold from a single source at which the PSA Rules are engaged. The Judge concluded that the enactment of the PSA Rules dealt with a particular, but quite different, potential for tax evasion and4 At [25] and [29].5 Hadlee v Commissioner of Inland Revenue [1989] 2 NZLR 447 (HC); aff'd [1991] 3 NZLR 517 (CA); aff'd [1993] 2 NZLR 285 (PC).did not indicate a legislative purpose with regard to income derived by a person conducting an independent business.6[52] The Judge's conclusion under the first heading was that the objective purpose of the formation of the companies was to adopt a normal and permissible structure for the conduct of a business. 7 There is no challenge to that conclusion. [53] In dealing with the fixing of the salaries paid to the respondents, the Judge discussed the contention made on their behalf that a commercially realistic salary was not a concept known to tax law and was not relevant to determining whether a particular arrangement constituted tax avoidance. The Judge relied in part on evidence from an experienced tax practitioner, Mr J B Shewan, a chartered accountant and principal of a leading accounting firm. Mr Shewan's evidence was to the effect that, despite his extensive experience as a tax practitioner, he was unfamiliar with the concept of a commercially realistic salary in the context of a family company whether for persons in the respondents' position or for any other taxpayer employed by a family company. He went on to assert that there was no such concept within the scheme of the Act. Objection was taken to part of Mr Shewan's evidence, but the Judge found his evidence helpful and did not consider it crossed the boundary to an impermissible extent. 8 Before us, Mr Goddard renewed his objection to Mr Shewan's evidence. I deal with this objection below. [54] The Judge then discussed the proposition that, except in specially defined situations, the Act does not dictate the level of income which a particular taxpayer must earn. 9 In general, the Judge considered that the level of payments from an employer to an employee will be determined by market forces 10 and concluded after a discussion of the relevance of the goodwill paid by the employer company that: 116 At [42].7 At [48].8 At [55].9 At [57] and [58].10 At [57].11 At [67].[67] For these reasons, I find nothing in the scheme and purpose of the Act which supports the proposition that payment of a commercially realistic salary in non arms length transactions is a general and over-riding requirement of the Income Tax Act. I do not consider that the basis upon which Mr Lyne's calculation of a commercially realistic salary has been made demonstrates that the fixing of the salary is part of a tax avoidance arrangement. I am supported in that conclusion by Mr Shewan's evidence to the effect that, in his very extensive experience as a tax practitioner, he has not found that tax practice has recognised the existence of the concept of a commercially realistic salary.[55] Addressing the issue in Mr Penny's case of the relevant cashflow and the availability of funds to Mr Penny personally by way of loans made through the trust, the Judge noted the respondents' objection to this evidence on the basis that it was outside the terms of the statements of position exchanged between the parties and was precluded from consideration by virtue of s 138G of the Tax Administration Act 1994. The Judge did not find it necessary to determine whether, in strict terms, the Commissioner was barred from raising this aspect of the case, 12 but dealt with the issue in any event. [56] He stated:[70] Circularity of money flows can be an important indicator of artificiality in an arrangement, and so an indicator of tax avoidance. In this case, what is relied upon is not a circulatory of flows, but a situation where the same economic outcome has been reached by a different legal route, and with different tax consequences from those which the Commissioner contends are appropriate. [57] After noting some difference of view between the minority and the majority of the members of the Supreme Court in the Ben Nevis case as to the importance of form and substance, the Judge said:[71] I approach the question in this case on the basis that the legal form by which the economic consequence of access to the funds by the taxpayer was effected must be respected, except to the extent that the scheme and purpose of the Act requires that another legal form for achieving that economic substance must be adopted, so that the use of the chosen legal form is a device to avoid the adoption of the correct legal form. [58] The Judge went on to say:12 At [69].[71] My conclusions to that effect are not altered by the fact that, in another capacity, Mr Penny was able to obtain the use of funds derived from the income of the practice, upon which tax had been paid both by the company and, as appropriate, by the trust in respect of dividends derived from the company. [72] There are two (or possibly more) potential routes which might be chosen, by which the income of the practice may ultimately be available to the taxpayer. Each of those routes will have different tax consequences. There is no suggestion of tax avoidance in the route actually chosen here: the tax applicable to the money flows has been paid. The fact that Mr Penny has the ultimate benefit of the funds can be an indicator of tax avoidance only if the scheme and purpose of the Income Tax Act is such as to require that, if he is to receive the ultimate benefit, it is permissible for him to do so only by deriving the funds as personal income. For the reasons I have given, I find that the scheme and purpose do not so require.[59] The final step in the Judge's decision was to view the matter overall to consider whether, despite his finding that there was no tax avoidance in the constituent parts of the arrangement, there was nevertheless tax avoidance in the whole. The Judge described the Commissioner's contention as depending on the fundamental proposition that income from a business that is dependent on the personal exertions of an individual is intended to be taxed as the income of that individual. The Judge was unable to accept that blanket proposition flowed from the scheme and purpose of the Act. [60] His conclusion was that the arrangement as a whole was not one which had the purpose or effect of tax avoidance or, if it did, any such purpose or effect was merely incidental to the purpose of adopting the corporate form of practice. 13The relevant statutory provisions[61] Section BG1 of the Act provides that a tax avoidance arrangement is void as against the Commissioner for income tax purposes. Where tax avoidance is found, the Commissioner may counteract tax advantages obtained. 14 Relevant terms defined in s OB1 are:13 At [81].14 Sections BG1(2) and GB1(1).Arrangement means any contract, agreement, plan, or understanding, (whether enforceable or unenforceable), including all steps and transactions by which it is carried into effect.Tax avoidance, in sections BG 1, EH 1, EH 42, GB 1, and GC 12, includes— (a) Directly or indirectly altering the incidence of any income tax: (b) Directly or indirectly relieving any person from liability to pay income tax: (c) Directly or indirectly avoiding, reducing, or postponing any liability to income tax.Tax avoidance arrangement means an arrangement, whether entered into by the person affected by the arrangement or by another person, that directly or indirectly – (a) Has tax avoidance as its purpose or effect; or (b) Has tax avoidance as one of its purposes or effects, whether or not any other purpose or effect is referable to ordinary business or family dealings, if the purpose or effect is not merely incidental.The Supreme Court's decision in Ben Nevis15[62] As the Supreme Court has noted, general anti-avoidance provisions have been a feature of New Zealand's tax legislation since 1878. Deceptive in their simplicity, they have not always been easy to apply in practice. The Supreme Court in Ben Nevis has undertaken a comprehensive and helpful review of the history of the legislation and the leading decisions made under it. The scheme and purpose approach adopted in earlier decisions has been endorsed in general terms but with some important clarifications. A key concept clarified by the Court is the relationship between specific tax provisions and a general anti-avoidance provision. While it has long been accepted that compliance with specific tax provisions does not oust the application of the general anti-avoidance provision, the Supreme Court has rejected the approach adopted by Richardson J in the Challenge Corporation16case which effectively reconciled conflicting provisions by reading down the scope of the general avoidance provision. 17 The Supreme Court also rejected a suggestion15 Ben Nevis Forestry Ventures Ltd v Commissioner of Inland Revenue [2008] NZSC 115, [2009] 2 NZLR 289.16 Commissioner of Inland Revenue v Challenge Corporation Ltd [1986] 2 NZLR 513 (CA).17 Ben Nevis, at [89].made by the Privy Council in the Auckland Harbour Board18 case that the role of anti-avoidance provisions may be as a long-stop. [63] The Supreme Court decided that: 19(a) the reconciliation of specific and general anti-avoidance provisions requires a "principled approach which gives proper overall effect to statutory language that expresses different legislative policies"; (b) decisions on individual cases are to be made through "the application of a process of statutory construction focusing objectively on features of the arrangements involved, without being distracted by intuitive subjective impressions of the morality of what taxation advisers have set up"; (c) the specific tax provisions and the general anti-avoidance provisions are to be construed together so as to give appropriate effect to each; and (d) whether an arrangement constitutes tax avoidance will depend on whether the taxpayer's use of the specific statutory provision has occurred in a manner that is consistent with Parliament's purpose, determined by an objective analysis of the overall scheme and purpose of the Act. [64] These principles are expanded upon in the following passages:[102] It is accordingly the task of the courts to apply a principled approach which gives proper overall effect to statutory language that expresses different legislative policies. It has long been recognised those policies require reconciliation. The approach must ensure that the particular case before the court is examined by reference to the respective legislative policies. It must enable decisions to be made on individual cases through the application of a process of statutory construction focusing objectively on features of the arrangements involved, without being distracted by intuitive subjective impressions of the morality of what taxation advisers have set up.18 Commissioner of Inland Revenue v Auckland Harbour Board [2001] 3 NZLR 289 at [11] per Lord Hoffman.19 At [102] and [103].[103] We consider Parliament's overall purpose is best served by construing specific tax provisions and the general anti-avoidance provision so as to give appropriate effect to each. They are meant to work in tandem. Each provides a context which assists in determining the meaning and, in particular, the scope of the other. Neither should be regarded as overriding. Rather they work together. The presence in the New Zealand legislation of a general anti-avoidance provision suggests that our Parliament meant it to be the principal vehicle by means of which tax avoidance is addressed. The general anti-avoidance regime is designed for that purpose, whereas individual specific provisions have a focus which is determined primarily by their ordinary meaning, as established through their text in the light of their specific purpose. In short, the purpose of specific provisions must be distinguished from that of the general anti-avoidance provision. [104] Parliament must have envisaged that the way a specific provision was deployed would, in some circumstances, cross the line and turn what might otherwise have been a permissible arrangement into a tax avoidance arrangement. Ascertaining when that will be so should be firmly grounded in the statutory language of the provisions themselves. [105] The key statutory concept in the general anti-avoidance provision is of a tax avoidance arrangement, as Parliament has defined it. By means of the definition of "tax avoidance", a tax avoidance arrangement includes an arrangement which directly or indirectly alters the incidence of any income tax. It is arrangements of that and allied kinds which are void against the Commissioner under s BG 1(1). An arrangement includes all steps and transactions by which it is carried out. Thus, tax avoidance can be found in individual steps or, more often, in a combination of steps. Indeed, even if all the steps in an arrangement are unobjectionable in themselves, their combination may give rise to a tax avoidance arrangement. [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 will 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. [107] When, as here, a case involves reliance by the taxpayer on specific provisions, the first inquiry concerns the application of those provisions. The taxpayer must satisfy the court that the use made of the specific provision is within its intended scope. If that is shown, a further question arises based on the taxpayer's use of the specific provision viewed in the light of the arrangement as a whole. If, when viewed in that light, it is apparent that the taxpayer has used the specific provision, and thereby altered the incidence of income tax, in a way which cannot have been within the contemplation and purpose of Parliament when it enacted the provision, the arrangement will be a tax avoidance arrangement. For example, the licence premium was payable for a "right to use land", according to the ordinary meaning of those words, which of course includes their purpose.But because of additional features, to which we will come, associated primarily with the method and timing of payment, it represented and was part of a tax avoidance arrangement. [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 by an important consideration. So will the role of all relevant parties and any relationship they may 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 is 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 the 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.[65] Of particular relevance to the present case are the observations made by the Supreme Court to the effect that: 20(a) the manner in which the arrangement is carried out will often by an important consideration; (b) so too, the role of all relevant parties and any relationship they may have with the taxpayer; (c) the economic and commercial effect of transactions may be significant; and20 At [108].(d) 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 the specific provisions "in an artificial or contrived way".The Glenharrow decision 21[66] The Supreme Court delivered its decision in the Glenharrow Holdings case on the same day as Ben Nevis. While Glenharrow was concerned with the general anti-avoidance provision in the Goods and Services Tax Act 1985,22 the Supreme Court emphasised that the general anti-avoidance provision in the Goods and Services Tax Act was not concerned with the purpose of the parties, but with the purpose of the arrangement, objectively examined. Subjective purpose or motive is not relevant and the objective purpose of an arrangement is to be determined from its effect. 23[67] The approach adopted in Glenharrow, in the respects identified, applies equally in tax avoidance cases under the Income Tax Act 1994, notwithstanding slight differences in the wording of the general avoidance section under the Goods and Services Tax Act. [68] In Glenharrow, the Supreme Court also endorsed the approach adopted inBen Nevis, namely consideration of whether what was done is outside the purpose and contemplation of the relevant statutory provisions. The approach was summarised in the following passage:[40] The application to an arrangement of tax legislation such as s 76 of the GST Act is concerned with the "aim or end in view" of the arrangement. It is to be objectively assessed. And the assessment will principally be a matter of inference from the arrangement and its effect. The purpose of an arrangement will be deduced from the arrangement itself and its effect. The intention of the Act will be defeated if an arrangement has been structured to enable the avoidance of output tax, or the obtaining of an input deduction in circumstances where that consequence is outside the purpose and contemplation of the relevant statutory provisions. 21 Glenharrow Holdings Limited v Commissioner of Inland Revenue [2008] NZSC 116; [2009] 2 NZLR 359.22 Section 76.23 At [38], citing from the advice of the Privy Council in Ashton v Commissioner of Inland Revenue [1976] 2 NZLR 717 per Viscount Dilhorne at 722.[69] One final point relates to the burden of proof. It is for the taxpayer to show that the steps taken were within the purpose and contemplation of Parliament, and that the arrangement does not constitute tax avoidance. 24The nature and scope of the arrangement alleged[70] As already noted, the expression "arrangement" is very broadly defined. Something less than an enforceable contract may constitute an arrangement for tax purposes. It may include a plan or understanding and also embraces all steps and transactions by which an arrangement is carried into effect. The taxpayers accepted that there was an "arrangement" as defined, but submitted it was not open to the Commissioner to contend that the loans made to Mr Penny by his trust formed part of the arrangement. This issue is discussed below. [71] The essential elements relied upon by the Commissioner as constituting the tax avoidance arrangement were: (a) the decisions of the taxpayers in the relevant income years to operate their private practices through the company and family trust structure; (b) the decisions by the relevant companies and the individual taxpayers to pay the respondents a salary that was substantially less than a commercially realistic salary; (c) channelling the company profits to the trust and allowing the taxpayers to have the benefit of those funds without deriving such funds as their personal income; and (d) in Mr Penny's case, the decision to advance funds to him from the trust which enabled him to access those funds for his personal benefit. [72] Mr Goddard reiterated that the Commissioner did not challenge the legitimacy of the company/trusts structures adopted. Nor is sham alleged in any24 Ben Nevis, at [115].respect. Rather, the focus of the Commissioner's case is on the manner in which the structures were used including, most importantly, the decisions made by the taxpayers to allocate to themselves a salary from their respective companies which were (as the taxpayers candidly admitted) at levels substantially below those which would be appropriate in an arms-length commercial context. [73] Mr Goddard further submitted that the arrangements alleged by the Commissioner could be described either as separate tax avoidance arrangements in each income year, or as ambulatory arrangements which were varied from year to year by the decisions made in that year in respect of salary, dividends and cash flow. [74] Mr Harley criticised the Commissioner's approach as being essentially hindsight oriented and therefore inconsistent with the definition of "arrangement" and "tax avoidance arrangement" which, he submitted, essentially looked forward, ie, by the identification of an arrangement and then consideration of the steps and transactions by which that arrangement was carried into effect. [75] It appears that salaries were paid or credited to Mr Penny and then confirmed by shareholders' resolution after the end of the 2002 and 2003 income years. These resolutions also set the salary at the same level for the following years (2003 and 2004 respectively). In Mr Hooper's case, there were undated shareholders' resolutions in 2002 and 2003 to the same effect as those for Mr Penny. It is reasonable to assume that these resolutions were made after the end of the 2002 and 2003 income years. [76] As Mr Goddard submitted, the setting up of the company/trust structures provided the platform or opportunity for the respondents to take advantage of the changes in personal taxation rates and the lower company tax rate in the years in question. It is the decisions made by the respondents and confirmed by the shareholders of their respective companies in respect of salaries in those years, coupled with the decisions made as to dividends and cashflows which are said to constitute tax avoidance in an artificial and contrived way inconsistent with commercial and economic reality.[77] I consider that the decisions taken in these respects clearly amount to an agreement, plan or understanding in terms of the statutory definition of "arrangement". The fact that salary decisions may have been made after the end of the 2002 income year is beside the point. There must have been at least an understanding between the respective companies and the respondents as directors as to the level of drawings during that year which was then confirmed by shareholders' resolution after year end. And for the 2003 and 2004 years, the salaries were fixed by shareholders' resolution during those years. [78] I am satisfied that an "arrangement" is not limited to a specific transaction or agreement but may embrace a series of decisions and steps taken which together evidence and constitute an agreement, plan or understanding. Any such arrangement may be continued in each of the income years in question or may be varied from year to year. [79] As to the scope of the arrangement, Mr Harley submitted that s 138G of the Tax Administration Act 1994 precluded the Commissioner from raising the loans made to Mr Penny as part of the Commissioner's challenge. That section relevantly provides:138G Effect of disclosure notice: Exclusion of evidence 138G(1) Unless subsection (2) applies, if the Commissioner issues a disclosure notice to a disputant, and the disputant challenges the disputable decision, the Commissioner and the disputant may raise in the challenge only - (a) the facts and evidence, and the issues arising from them; and (b) the propositions of law, - that are disclosed in the Commissioner's statement of position and in the disputant's statement of position.[80] It is common ground that subs (2) does not apply here. [81] The Tax Administration Act provides for statements of position by the Commissioner and the disputant taxpayer in s 89M. The contents of the Commissioner's statement of position are described in s 89M(4);89M(4) (contents of Commissioner's statement of position) The Commissioner's statement of position in the prescribed form must, with sufficient detail to fairly inform the disputant, - (a) Give an outline of the facts on which the Commissioner intends to rely; and (b) Give an outline of the evidence on which the Commissioner intends to rely; and (c) Give an outline of the issues that the Commissioner considers will arise; and (d) Specify the propositions of law on which the Commissioner intends to rely.[82] In his statement of position, the Commissioner did not rely on the loans to Mr Penny as constituting part of the "arrangement" and there was no specific reference made to them. Mr Goddard emphasised, however, that s 89M(4) required the Commissioner only to state an outline of the facts and evidence on which he intended to rely. I accept that some latitude may be extended to the Commissioner or a disputant taxpayer in terms of s 138G as the Supreme Court noted in Ben Nevis.25But as the Supreme Court also stated, the disputes process is not a general inquiry into the taxpayer's liability to pay tax and the amount of that liability. The inquiry must be focused upon the terms of the dispute as raised and responded to by the taxpayer. The statutory regime requires "a more precise legal articulation of a party's case than is conventional with ordinary civil proceedings". In Ben Nevis, the taxpayer was prevented from introducing at a late stage an entirely separate and distinct basis for assessing the tax payable. [83] In this case, the relevance and significance of the loans made to Mr Penny does not appear to have been recognised until sometime after the exchange of the statements of position between the parties. Before the High Court, Mr Lyne's evidence discussed the loans and their significance in considerable detail and the Commissioner submitted that the fact and terms of the loan should be treated as part of the arrangement. It is not suggested that the respondents were taken by surprise by the evidence or that they suffered prejudice in not being able to respond to it.25 Ben Nevis Forestry Ventures Ltd v Commissioner of Inland Revenue [2008] NZSC 115, [2009] 2 NZLR 289 at [153] – [155].Rather, the point made by Mr Harley is that the evidence is not admissible by virtue of s 138G. [84] I accept Mr Goddard's submission that the cashflows as between OSCL and the trust were clearly raised in the Commissioner's statement of position as part of the "arrangement" and that the accounting records of the trust recorded both the receipt of the dividends from the company and their advance to Mr Penny. In these circumstances, I have concluded that it would be a step too far to preclude the Commissioner from relying on evidence of the advances. They were closely connected with the dividends received by the trust from OSCL, were evidenced in the trust's accounting records, and their existence would have been well known to Mr Penny and his accountant in their respective capacities. [85] While it is open for the Commissioner to rely on these advances as evidence in support of his submission that the "arrangement" was contrived or artificial, I do not consider that the Commissioner is entitled to rely on the loans as falling within the scope of the "arrangement" given that the Commissioner's statement of position was explicit in determining what was said to constitute the "arrangement" and made no reference to the loans in that respect.Did the "arrangement" directly or indirectly have tax avoidance as one of its purposes or effects?[86] There is no question that one of the effects of the arrangement relied upon by the Commissioner was to alter the incidence of the taxpayers' personal income in the income years at issue. That follows inexorably from the difference between the top personal marginal tax rate of 39 cents and the company tax rate of 33 cents. The Commissioner's case is that the difference of six cents in the dollar between company and personal tax rates was avoided to the extent that the salaries allocated to the respondents were set at commercially unrealistic levels. He submits that, viewed as a whole, the "arrangement" is properly described as artificial, contrived and beyond Parliamentary contemplation as a legitimate business arrangement.[87] In contrast, the case for the respondents is that the company/trust structure is a legitimate and accepted means of conducting business and that the respondents have simply taken advantage, as they are entitled to do, of the differential tax structure in New Zealand as Parliament contemplated was open to them. It is, and never has been, part of New Zealand tax law and practice for the Commissioner to challenge salary levels except in very limited contexts such as where an excessive salary is allocated to a spouse or relative for nominal services. Rather, the general approach has been to allow market forces to prevail in fixing salary or wage levels. The PSA Rules were enacted at the same time as the adjustment to the top personal tax rate to deal with situations where a company does not have a genuinely independent business and has a concentration of earnings from one source. As those Rules do not apply to the respondents companies, the proper inference is that Parliament did not intend that company income be attributed to individual employees in cases not falling within those Rules. [88] The first stage of the inquiry mandated by Ben Nevis26 is straightforward in the present case. There is no issue that, absent the general anti-avoidance provision, the respondents were entitled to take advantage of the differential tax rates applicable to individual and company taxpayers. The further question then arises whether, viewed in the light of the arrangement as a whole, the taxpayer has used the specific provisions of the tax legislation to alter the incidence of income tax in a way that cannot have been within the contemplation and purpose of Parliament. That involves a consideration of the scheme and purpose of the Act. [89] I commence with the PSA Rules. Mr Harley submitted that the enactment of the PSA Rules at the same time as the increase in the top personal tax rate was a strong indicator that Parliament intended to differentiate between companies falling within the PSA Rules and those which do not. He submitted that, in enacting the PSA Rules, Parliament had very largely "defined the territory" in relation to the attribution of company income to the individual providing services to the company and it was reasonable to infer that Parliament did not intend this constraint to extend to cases falling outside those Rules. Since it is common ground that the PSA Rules26 At [107].do not apply in the respondents' case, it could not be said that their business arrangements went beyond what Parliament had contemplated. [90] The general effect of the PSA Rules is stated in s GC 14B(1):(1) If, during an income year, a person (person A) purchases services from another person (person B) and the services are personally performed by a third person (person C), who is associated with person B, an amount must be attributed by person B to person C in accordance with section GC 14D in the same income year.[91] According to the Commentary on the Taxation (Annual Rates, GST and Miscellaneous Provisions) Bill 2000 in the section dealing with the proposed PSA Rules on the "Alienation of Income from Employment":Summary of proposed amendmentThe bill introduces an anti-avoidance rule broadly aimed at employees who circumvent the top personal tax rate of 39 percent by interposing a company, trust or partnership between themselves and their employer in order to have their income taxed at a lower rate. The rule will attribute what generally is, in substance, employment income to the employee. It supports the general anti-avoidance provisions of the Income Tax Act 1994. The attribution rule will apply for income tax purposes only, and will not have any impact on the commercial and/or legal consequences of transactions entered into by the interposed entity.Application dateThe attribution rule will apply from the income year beginning 1 April 2000, to coincide with the date on which the 39 percent top personal tax rate took effect. Arrangements made before 1 April 2000 will be subject to the rule.BackgroundThe attribution rule addresses the need to protect the PAYE tax base following the increase in the top personal tax rate, from 1 April 2000, to 39 percent. Anecdotal evidence suggests that simple avoidance schemes are being targeted at employees. Income tax legislation already contains general anti-avoidance rules that can be used to counter such avoidance activity. Experience has shown, however, that they are time-consuming and costly to apply. Relying on these rules to counter the expected rise in cases of alienation of income by employees would mean that the results would most likely not become public through the courts for several years. Such delays could seriously erode the additional tax revenue intended by raising the top personal tax rate to 39 percent. The proposed legislation addresses this problem by providing explicit rules. [92] This material makes it clear that Parliament did not intend the PSA Rules to be a comprehensive attempt to define all the activities that would constitute tax avoidance in the wake of the increase in the top personal tax rates. Rather, the PSA Rules were intended as a mechanism to restrain tax avoidance in a defined situation more rapidly than would be possible using the general anti-avoidance provision. [93] I do not think it proper to infer from the fact that Parliament has addressed the prospect of tax avoidance in one set of circumstances, that it did not contemplate that the general tax avoidance provision might apply in other situations. As the Supreme Court has stated, the presence in the Act of a general anti-avoidance provision suggests that Parliament meant it to be the principal vehicle to address tax avoidance. 27 And, as Lord Templeman observed in delivering the judgment of the majority of the Privy Council in the Challenge Corporation case: 28Tax avoidance schemes largely depend on the exploitation of one or more exemptions or reliefs or provisions or principles of tax legislation. Section 99 [the general anti-avoidance provision then in force] would be useless if a mechanical and meticulous compliance with some other section of the Act were sufficient to oust s 99.[94] Moreover, as noted by the Supreme Court in Ben Nevis, one of the reasons for the general anti-avoidance provisions being expressed in broad terms, is the difficulty in predicting in advance the ingenuity of taxpayers in adapting the forms in which they do business. [95] I conclude that the enactment of the PSA Rules does not control the determination of the question whether the arrangements adopted in the present case were within the scheme and purpose of the Act. The fact the PSA Rules are not engaged does not preclude reliance by the Commissioner on s BG 1. [96] Potentially of more substance is Mr Harley's submission that the Act permits taxpayers to choose the manner in which they do business. In particular, he submitted that the Act permits taxpayers to choose whether they conduct their business as sole traders, in partnership or as an incorporated company. Mr Harley further submitted that, as a general rule, a company is at liberty to remunerate its27 At [103].28 Commissioner of Inland Revenue v Challenge Corporation Ltd [1986] 2 NZLR 556 at 559.employees at such levels as it sees fit without interference from the Commissioner. He submitted that the Judge, supported by the evidence from Mr Shewan, was right to conclude that there was no concept under the Act of a commercially realistic salary. [97] Mr Goddard was critical of much of the content of Mr Shewan's evidence, submitting that it went well beyond the role of an expert witness. I agree that substantial parts of Mr Shewan's evidence amounted to legal submission or advocacy which should have no place in the evidence of an expert witness. It ought more properly to have come from counsel. To that extent, I put Mr Shewan's evidence to one side. But I see no objection to his evidence about taxation practice, based as it was on his extensive experience in that field. [98] Mr Harley submitted there may be a variety of perfectly legitimate reasons for family companies, such as those involved in the present case, to allocate salary to their working directors at a level below that which would be appropriate if they were employed at arms-length by an independent employer. Several of his examples are readily distinguishable but those less readily distinguishable include situations where a company elects to pay a working director much less than a market rate because the company is in a development phase and there is a need to build up capital; where a company needs to purchase a substantial asset for the purpose of its business; where the director does not work on a full-time basis; or where the company has had a poor financial year and any profits are insufficient to pay a proper salary. Mr Harley gave further examples such as a person who wishes to donate his or her time to a company engaged in charitable purposes at a lower than market rate or even without remuneration; or, closer to the present case, the directors and shareholders of the company wish to maximise the transfer of profit from the company to trustee shareholders for their benefit. [99] In short, Mr Harley submitted it was entirely within the discretion of the company, in consultation with the directors and shareholders, to determine the appropriate level of salary or, indeed, whether any salary is paid at all.[100] In response to this submission, Mr Goddard reiterated that the Commissioner was not advancing the concept of a commercially realistic salary on a stand-alone basis. Rather, he relied on all the circumstances as evidence supporting the existence of a tax avoidance arrangement. He identified the key features as: (a) the avoidance of the application of the top personal tax rate to income generated by the personal skill and exertion of the taxpayers (in this respect, Mr Goddard relied particularly on Commissioner of Inland Revenue v Hadlee); 29(b) the retention of control by the taxpayers over the whole of the income generated (notwithstanding the company/trust structure); (c) the application of the income earned for the benefit of the taxpayers and their families; and (d) the decision or agreement of the taxpayers respectively to fix their salary levels at artificially low levels which did not conform with commercial or economic reality.The significance of the Hadlee case[101] Hadlee was concerned with the assignment by a partner in a national accountancy firm of a portion of his partnership income to a trust whose beneficiaries essentially comprised members of his family. The arrangement was challenged by the Commissioner of Inland Revenue under the general anti-avoidance provision then in force. 30 It was held by Eichelbaum CJ at first instance, and subsequently affirmed on appeal by this Court and the Privy Council that, despite the assignment, the income of Mr Hadlee from the partnership was all derived by him for tax purposes and that, in any event, the assignment and associated arrangements constituted tax avoidance.29 Hadlee v Commissioner of Inland Revenue [1989] 2 NZLR 447 (HC); (1991) 13 NZTC 8,116; [1991] 3 NZLR 517 (CA); [1993] 2 NZLR 385 (PC).30 Income Tax Act 1996, s 99.[102] Mr Goddard properly acknowledged that Hadlee is distinguishable from the present case to the extent that the Commissioner accepts that the income from the practices of the respondents is derived by their respective companies. But Mr Goddard relied strongly on Hadlee for other reasons. First, he submitted that tax legislation in New Zealand has consistently set its face against the diversion of income arising from the personal exertion of taxpayers and that this is a relevant consideration when considering whether the arrangement in the present case was within Parliamentary contemplation. Secondly, Mr Goddard submitted there were other important considerations taken into account in Hadlee which have application in the present case. [103] I accept that the Commissioner's decision in the present case does gain some support from Hadlee in the respects Mr Goddard has identified. [104] In the Court of Appeal, Richardson J discussed the topic of personal exertion income at some length, concluding that the income tax legislation requiring wage and salary earners to pay tax on their earnings, applies equally to the earnings of the self-employed from their personal exertions.31 He noted that: common experience confirms that, in general, working professionals earn their incomes from their exertions and if they do not perform they may be fired by their partners. There is no justification in principle for differentiating between salary and wage earners and professionals whose income is the product of their personal exertion. In either case the person whose personal exertion earns the income derives the income. It would be wrong to impute an intention to Parliament that income splitting with its inevitable undermining of the graduated rate structure should be widely available to professional and commercial taxpayers although denied to salary and wage earners.[105] The conclusions of the Court of Appeal on this point were upheld by the Privy Council.32[106] While acknowledging that Hadlee cannot be applied directly to the present case since the practice income was derived from the respondents' respective companies, the issues discussed by Richardson J in Hadlee suggest that when considering whether particular arrangements constitute tax avoidance, the adoption31 At 533.32 Hadlee [1993] 2 NZLR 385 at 389.of business structures and other means which have the effect of diverting or splitting income generated by the personal exertions of individuals in a way which undermines the graduated personal tax regime is a relevant consideration in assessing whether the arrangements are within Parliamentary contemplation in the sense discussed in Ben Nevis. [107] I also accept there are some factual similarities in Hadlee which, in a general sense, bear upon the present case particularly on the issues of artificiality and contrivance. These are conveniently summarised in the judgment of Eichelbaum CJ at first instance: 33First the objector undertook, post assignment, to contribute 100% of his working time for 60% of the remuneration otherwise receivable. Second, the result of the arrangement, if effective, was that the objector still had available to him, through the vehicle of the trust, the whole of the partnership income, subject (so far as the assigned income was concerned) to the provisions limiting its application to the specified beneficiaries. They however, with himself, comprised the family group for whose primary benefit one would expect the objector to have expended the income prior to the establishment of the arrangement. But as demonstrated, the total tax liability generated by the income was reduced significantly. It is plain that the arrangement relieved the objector from liability to pay tax, or avoided or reduced the liability, or altered the incidence of his tax. Those conclusions would have followed under the previous s 108, as interpreted in Mangin v Commissioner of Inland Revenue, without the need to resort to the more explicit definitions contained in the new section. In my opinion the purpose and effect of the arrangement was tax avoidance. Even if it were possible to regard that as one purpose and effect only (the other being to enable the objector's dependants to accumulate assets which would be secure from the risk of claims against the partnership) I cannot view it as "merely incidental". The potential tax benefits were too significant and obvious. I agree with the submission on behalf of the Commissioner, that it would require a considerable degree of naivety to conclude that they played merely an incidental part in the scheme.[108] The members of this Court had no difficulty in agreeing with Eichelbaum CJ on this point. Cooke P attached: 34 particular weight to the fact that in return for a relatively minor monetary consideration, some $16,000, most of which was actually paid out of partnership drawings, the partner at the age of 39 surrendered to his family trust 40 per cent of his future earnings in a leading accountancy practice of international statute (sic), yet covenanted to continue diligently to attend full33 Hadlee [1989] 2 NZLR 447 and 470.34 At 524.time to the partnership business. The return to the trust in the first two years represented 123 per cent and 159 per cent of the monetary price.[109] Similarly, Richardson J held, in agreement with Cooke P, that he had no doubt that the arrangement fell squarely within the general tax avoidance provision.35Conclusions[110] The Supreme Court has made it clear in Ben Nevis that the adoption of legitimate legal structures or entities will not be a barrier to a finding of tax avoidance if the arrangements are artificial, contrived, or amount to a pretence. Findings of that character will be influenced by assessing them in the light of commercial reality and the economic effect of the arrangements. The conclusion of the Supreme Court in this respect is supported by a substantial body of precedent both in this Court and the Privy Council. [111] Reference may also be made to the decisions of the Privy Council inCommissioner of Inland Revenue v Auckland Harbour Board36 and Miller v Commissioner of Inland Revenue37 . As this Court stated in Commissioner of Inland Revenue v BNZ Investments Limited:38[40] Line drawing and the setting of limits recognise the reality that commerce is legitimately carried out through a range of entities and in a variety of ways; that tax is an important and proper factor in business decision making and family property planning; that something more than the existence of a tax benefit in one hypothetical situation compared with another is required to justify attributing a greater tax liability; that what should reasonably be struck at are artifices and other arrangements which have tax induced features outside the range of acceptable practice - as Lord Templeman put it in Challenge at p 562, most tax avoidance involves a pretence; and that certainty and predictability are important but not absolute values.[112] I have concluded that the identified arrangements in this case not only had the effect of altering the incidence of income tax (to the extent of the difference between the top personal tax rate of 39 cents and the company rate of 33 cents) but this was35 At 533.36 Commissioner of Inland Revenue v Auckland Harbour Board [2001] 3 NZLR 289 at [11].37 Miller v Commissioner of Inland Revenue [2001] 3 NZLR 316 at [10].38 Commissioner of Inland Revenue v BNZ Investments Limited [2002] 1 NZLR 450.also at least one of its purposes. I have also decided that the purpose or effect of altering the incidence of tax was not merely an incidental purpose or effect. My reasons for these conclusions follow. [113] There are two striking features of the arrangements adopted by both respondents. The first is that each had been conducting their respective practices as orthopaedic surgeons on their own account and then chose to incorporate their practices. In Mr Hooper's case, that occurred in 2000, coinciding with the increase in the top personal tax rate. Mr Penny's company was incorporated earlier in 1997. There is, and could be, no valid criticism of the adoption of the corporate vehicle as such. But it is the combination of that fact with the second striking feature which I consider to be significant. In each case, the net income before tax each respondent was receiving was dramatically reduced from the year 2000 onwards – in Mr Hooper's case from about $650,000 to $120,000 per annum and in Mr Penny's case from $302,000 to $125,000 and then to $100,000 thereafter. Their reduced salaries in the company structure represented approximately 18 per cent and 33 per cent respectively of the net pre-tax income they previously enjoyed. [114] Both respondents accepted without hesitation that these salaries were at levels substantially below what could have been expected if they had been employed independently at arms-length. On Mr Lyne's evidence, Mr Hooper's salary should have been, on average, about $558,000 (compare the $120,000 he was actually paid) and Mr Penny's should have been $633,000 (compare the $100,000 he was actually paid). [115] As earlier noted, it is no coincidence that this marked drop in the salaries paid in the disputed tax years coincided with the increase in the top personal tax rate which came into effect on 1 April 2000. I am satisfied that the only realistic inference to draw is that at least one of the purposes of the arrangements was to alter the incidence of income tax in the way the Commissioner alleges. [116] I accept Mr Harley's submission that, in general terms, the Act is not concerned with the level of salaries paid to employees in family-owned companies such as those incorporated by the respondents. Or, indeed, in the level of salaries orwages more generally. I also accept that there may be good reasons why an employee would agree with an employer to accept a salary reduction. The reasons discussed at [98] above may all have legitimacy in different contexts. [117] But none of these reasons has any application here. Both Mr Hooper and Mr Penny continued to devote their personal exertions to the generation of income from their practices exactly as they had before when receiving income at much higher levels. There was no diminution of hours of work or degree of effort on their part. Nor was there any material reduction in gross income before expenses, or any identified need for increased capital or other expenditure which might have justified a reduced salary. It was not suggested there were charitable or other reasons that might have afforded legitimate reasons for the salary reductions. [118] Consideration must also be given to where the increased company profits resulting from the reduced salaries paid to the working directors went and how that was achieved. In each case the surplus profits were transferred by way of dividend to the respective family trusts as shareholders. The effect of that was to benefit the respondents and their families. While there could be no valid suggestion that the mere adoption of the company/trust structures was improper, this structure was nevertheless the vehicle by which they were able to obtain the advantage of the lower company tax rate while still enjoying the full benefit of the income of the companies for themselves personally and their families. This was particularly marked in Mr Penny's case where over $2 million in company profit was diverted via his family trust to himself in the form of unsecured, interest-free loans with no specified term for repayment. The effect of this was to deplete the net equity of the company over the relevant years to only $46,000 and to increase the trust's assets by $2.1 million, 94 per cent of which was represented by the loans made to Mr Penny personally. 39[119] There can be no doubt that all these arrangements were achieved by the adoption of the company/trust structures; the ability of the respondents to effectively39 See the more detailed analysis at [31]-[35] above.control the relevant salary levels and cashflows in their capacities as directors of their companies; and through their control of the family trusts. 40[120] I accept there may have been a secondary purpose or effect referable to ordinary business or family dealings, namely to benefit the respondents' family trusts. But the benefits flowing to the trusts could equally have been achieved by the respondents being paid salaries at levels which were commercially realistic having regard to their personal circumstances and those of their companies. Their enhanced personal income could then have been applied (after payment of the appropriate level of tax) for the benefit of themselves and their families. [121] I do not attach any weight to the suggestion that the company structure was necessary to protect the respondents from negligence claims given the existence of the ACC legislation and the fact that a company structure would not avoid personal responsibility in respect of any such claims in any event. [122] When taking into account the circumstances overall, the avoidance of tax was more than a merely incidental purpose or effect of the arrangement. The salaries adopted were so far removed from commercial reality as to be contrived and artificial. They could not be regarded in any sense as within the acceptable limits of commercial practice. 41 It could not have been within the contemplation of Parliament that a company director/employee could adopt a salary of less than one- fifth of a proper commercial salary and thereby secure significant tax advantages while still receiving, in practical terms, the benefit of the company's entire net income for himself and his family. In these respects, the case has some parallels with Hadlee for reasons discussed at [107] and [108] above. [123] Mr Harley relied on the decision of Cooke J (as he then was) in Loader v Commissioner of Inland Revenue42 for the proposition that the adoption of a company/trust structure was not to be regarded as having the consequence of avoiding tax under s 108 of the Land and Income Tax Act 1954. But the facts of the40 Compare the decision of Henry J in Lawler v Commissioner of Inland Revenue (1973) 1 NZTC 61,091.41 See, for example, the conclusion reached by Perry J in Wells v Commissioner of Inland Revenue(1973) 1 NZTC 61,094.42 Loader v Commissioner of Inland Revenue [1974] 2 NZLR 472.case are not comparable with the present. There was a transfer to a company of the greater part of the heavy machinery utilised in the taxpayer's business and no suggestion of an artificially low salary being paid to the working director in the company. [124] There are further facts which tend to emphasise the artificiality of the arrangement. For example, when Mr Hooper established his company, the goodwill paid was only $300,000 representing less than half his net annual income before tax. And, in Mr Penny's case, the goodwill paid by POS was a mere $100,000 and was then increased to just over $1 million at the time of the immediate on-sale to OSCL. The ten year employment contract he entered into with POS was not in fact assigned to OSCL and, in any event, was not sufficiently substantial to justify such a large goodwill figure. In reality, the company was most unlikely to have enforced the contract against the wishes of Mr Penny, yet the $1 million goodwill figure enabled him to receive a tax-free capital dividend of $900,000 from POS. [125] I am conscious of the practical consequences which may flow from this decision, including the uncertainty which may be created for the Commissioner as well as for taxpayers and their advisers. To what extent and in what circumstances will it be necessary to review the salary levels of employees (particularly in family companies) to determine on which side of the line their salary may fall? It is important to recognise, however, that this decision should not be regarded as establishing a principle that salary levels in family companies which are below the levels which could be expected in an arms-length situation, are necessarily to be regarded, without more, as evidence of a tax avoidance arrangement. [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. [127] As the Supreme Court noted in Ben Nevis in response to a submission by the appellants that tax avoidance legislation should be interpreted in a way which gives taxpayers reasonable certainty in tax planning:[112] But Parliament has left the general anti-avoidance provision deliberately general. That approach has been retained despite the introduction of a civil penalties regime in relation to taxpayers who take certain types of incorrect tax position. The courts should not strive to create greater certainty than Parliament has chosen to provide. We consider that the approach we have outlined gives as much conceptual clarity as can reasonably be achieved. As in many areas of the law, there are bound to be difficult cases at the margins. But in most cases we consider it will be possible, without undue difficulty, to decide on which side of the line a particular arrangement falls.[128] The Supreme Court continued this theme in Glenharrow Holdings Limited:[48] It may be said, and indeed the appellant does say, that to approach the question of the intent and application of the Act in this way is not to respect the bargain struck by the parties and would allow the Commissioner to restructure their bargain for them, with different GST consequences, and would thus be productive of uncertainty. But that uncertainty is inherent where transactions have artificial features combined with advantageous tax consequences not contemplated by the scheme and purpose of the Act. There will also inevitably be uncertainty whenever a taxing statute contains a general anti-avoidance provision intended to deal with and counteract such artificially favourable transactions. It is simply not possible to meet the objectives of a general anti-avoidance provision by the use, for example, of precise definitions, as may be able to be done where an anti-avoidance provision is directed at a specified type of transaction.Result[129] For the reasons given, I would allow the appeal and declare that the arrangements identified by the Commissioner in respect of the income tax years 2002, 2003 and 2004 are void against the Commissioner for income tax purposes in terms of s BG 1 of the Income Tax Act 1994. We are not asked to determine the fiscal effects of this determination, but I would reserve leave to apply in case any consequential questions arise.[130] I would allow costs against the respondents jointly and severally for a complex appeal on a band A basis and usual disbursements. [131] Costs in the High Court were left for the parties to agree upon. We are not aware of the outcome. I would allow the appellant costs in the High Court as agreed or fixed by that Court.HAMMOND J[132] I have had the advantage of reading, in draft, the judgments of Randerson J and Ellen France J. I am particularly grateful to Randerson J for carefully setting out the background to the case, and the various arguments which have been raised. [133] I agree with the result arrived at by Randerson J, and the disposition of the appeal and the orders proposed by him in [129] to [131] of his judgment. I do so substantially for the reasons given by him. But given the importance of the appeals it may be useful to add some short observations of my own. [134] There has long been a debate in New Zealand (and elsewhere for that matter) as to the appropriate relationship between the body of specific tax rules, and general anti-avoidance provisions. It is easy to see why this is so. The taxation legislation is a monumental and ever-growing body of specific rules. Taxation advisors and the Commissioner perform a somewhat ungainly pirouette about each other, year in and year out, and it has to be said at some expense to all involved in the process, as to the application of these rules. Then, a blanket, code-type provision is thrown over the top of this assemblage of rules. And such a provision has the capacity, on the face of it, to drive straight through the heart of a carefully and often elaborately constructed scheme which has been stitched together and appears to meet all the specific rules. [135] The existence of this difficult legislative assemblage has evoked various responses over the years. Historically, one result (based on a now very outmoded view of legislative interpretation) was to say that because of its highly coercive and even penal effect, the legislation should be strictly construed. Inevitably that would lead to a reading down of the very wide-ranging anti-avoidance provision. At the other end of the spectrum were those who contended that if Parliament could notforesee and proscribe that which was really intended to be caught, not much account should be taken of the anti-avoidance provision. It was at best a distant long stop. There were even those who contended that because the anti-avoidance provision is so "at large" and "vague" and cannot be given a discernable principled basis, it should be cast into the limbo of something to be politely ignored. [136] In Ben Nevis Forestry Ventures Ltd v Commissioner of Inland Revenue, 43 as I apprehend it, the Supreme Court of New Zealand has authoritatively, if by a majority, held that the foregoing has been something of a false debate: both the specific rules and the New Zealand anti-avoidance provision have to be given effect to, and they are complementary. [137] That works in this way. The first inquiry is as to the application of the specific rules: "...the use made of the specific provision [must be] within its intended scope". 44 If it is not, that is the end of the inquiry at that point. [138] But if the use is within the specific provision, the second question arises: whether the taxpayers' "use of the specific provision viewed in the light of the arrangement as a whole" 45 is lawful: 46If ... it is apparent that the taxpayer has used specific provision, and thereby altered the incidence of income tax, in a way which cannot have been within the contemplation and purposes of Parliament when it enacted the provision, the arrangement will be a tax avoidance arrangement.[139] There is nothing unusual in the law about such an approach. As only one example, intellectual property practitioners and Judges have long been used to the proposition that trade secret protection (which encourages secrecy) and patent law protection (which encourages openness) are complementary in the working of that subset of the law, difficult though that can be in practice. 47 And much of43 Ben Nevis Forestry Ventures Ltd v Commissioner of Inland Revenue [2008] NZSC 115, [2009] 2 NZLR 289.44 At [107].45 At [107].46 At [107].47 Perhaps the most famous enunciation of this is in the decision of the United States Supreme Court in Kewanee Oil Co v Bicron Corp 416 US 470 (1974).constitutional law is about different principles having to work "in concert", and not cancel each other out. [140] The third limb of Ben Nevis, or perhaps more accurately a gloss on the second limb, is that "[t]he general anti-avoidance provision does not confine a court as to the matters which may be taken into account when considering whether a tax avoidance arrangement exists". 48 As the Supreme Court said, the way in which the arrangement is stitched together and the effect of it in economic and commercial terms may also be significant. 49 A combination of various elements may well be critical; in particular, the structuring of an arrangement so that the taxpayer gains the benefit of the specific provision in an artificial or contrived way. [141] The significance of this, in terms of juridical technique, is that the approach is not a particularistic one; in an avoidance case matters are to be approached in a more "rounded" way which is intended to give full effect to the overall legislative taxation scheme and purpose. [142] An approach formulated in these terms has a number of consequences, two of which are worth mentioning here. [143] First, there is undoubtedly some effect on the "certainty" of assessment of taxation liability in a given arrangement. Rule based jurisprudence is, intrinsically, easier and more certain: either something is within the rule, when it is properly understood, or it is not. [144] The effect of the construction placed on the taxation legislation by the Supreme Court is that the wider considerations postulated by Parliament are always going to be present. Whatever views may be taken of that as a matter of jurisprudential approach, or as to the practicalities of giving advice, that is what Parliament has done. And in avoidance cases it requires a more rigorous, and for that matter nuanced, approach by taxation advisors than a simple, "but this was within Rule X". What might be termed a purely doctrinal approach to taxation advice on avoidance is thereby left in its twentieth century waste-paper basket.48 At [108]49 At [108].[145] A second feature is that in undertaking that exercise, economic analysis and realities are expressly embraced as being relevant. It is perhaps worth making some further observations on this issue. [146] There is nothing new in the common law world about such a notion. For instance, in Gregory v Helvering50 in the 1930's, a very distinguished panel of American Judges of great intellectual prestige presided over by Learned Hand J had to deal with a case in which Mrs Gregory owned all the stock of United Mortgage Corporation, which held among its assets 1,000 shares of stock of the Monitor Securities Corporation. Mrs Gregory desired to liquidate the shares of the Monitor stock, but was not too enthusiastic about the two levels of taxation to which the proceeds from the sale would be subjected if she simply directed United to sell the Monitor stock, and then distribute the proceeds to herself. So she organised a new company, transferred Monitor stock to this new company three days after, dissolved the new company within the same week, caused it to transfer the Monitor shares to her as part of the dissolution, and recognised the gain as a capital gain. These transactions met all the formal requirements of a reorganisation under the U.S. Revenue Act of 1928. The result was that the transfer of Monitor stock to the new company would be tax free, and the subsequent liquidation of the new company would give rise to capital gains in the hands of the shareholder who had received the distribution of shares. The Commissioner of course said that the result of the transaction was the same as a simple dividend distribution. He sought to tax it as such. This raised the issue, should the transaction be characterised according to the form or the economic result of what had occurred? [147] In possibly the most famous passage in American tax law Learned Hand J said that: 51... the meaning of a sentence may be more than that of the separate words, as a melody is more than the notes, and no degree of particularity can ever obviate recourse to the setting in which all appear, and which all collectively create. If what was done here was what was intended by [the statute], it is of no consequence that it was all an elaborate scheme to get rid of income tax, as it certainly was ... [But] the purpose of the section is plain enough: men engaged in enterprises ... might wish to consolidate, or divide, or to add to,50 Gregory v Helvering 69 F 2d 809 (2 nd Cir. 1934).51 At 810-11.or subtract from, their holdings. Such transactions were not considered as realising any profit, because the collective interests still remained in solution. But the underlying presupposition is plain that the readjustment shall be undertaken for reasons germane to the conduct of the venture in hand, not as an ephemeral incident, egregious to its prosecution ... to dodge the shareholder's taxes is not one of the transactions contemplated as a corporate "reorganisation" ... we cannot treat as inoperative the transfer of shares ... the transfer passed title ... and the taxpayer became a shareholder in the transferee. All these steps were real and their only defect was that they were not what the statute means by a reorganisation.[148] As Isenberg correctly noted Learned Hand J's reasoning "has left echoes in every corner of the tax law" in the United States, and beyond. 52[149] Ironically, at almost the same time, on the other side of the Atlantic in the famous case of Inland Revenue Commissioner v Duke of Westminster,53 the House of Lords was establishing a different set of principles in response to the same kind of problem:• a revenue act is to receive a strict or literal interpretation;• a transaction is to be judged not by its economic or commercial substance but by its legal form; and• a transaction is effective for tax purposes even if it has no business purpose, having been entered into solely to avoid tax. [150] The Duke of Westminster proved to be a durable old fellow, but by the 1980's the House of Lords had begun to endorse a purposive statutory interpretation approach to taxation, and gradually recognised the relevance of the economic substance doctrine. It did so however not by endorsing a doctrine of economic substance which was as broad as the American common-law notion. Rather, in the tradition of Anglo-New Zealand jurisprudence, it saw the doctrine as having to be firmly anchored as a matter of statutory interpretation, not a free-standing anti- avoidance rule. The House of Lords was much exercised by this subject-area, and it is fair to say the jurisprudence in that Court was something of a roller-coaster. One52 See Joseph Isenberg "Musings on Form and Substance in Taxation" (1982) 49 U Chi. L. Rev 859 at 867.53 Inland Revenue Commissioner v Duke of Westminster (1936) AC 1 (HL).thinks for instance of Ramsay Ltd v Inland Revenue Commissioners,54 Furniss (Inspector of Taxes) v Dawson,55 Inland Revenue Commissioners v Burmah Oil Co Ltd,56 Commissioner of Inland Revenue v Challenge Corporation Ltd (PC),57Barclays Mercantile Business Finance Ltd v Mawson (Inspector of Taxes),58 andInland Revenue Commissioners v Scottish Provident Institution.59 What is significant however is that any notion that a "shelter strictly within the rules will save the transaction from tax consequences" is well gone, even in the UK. [151] There is still however the difficulty of what is meant by "economic effect". That has caused senior appellate courts some real difficulties. [152] The American doctrine is that a transaction lacks economic substance if it "cannot with reason be said to have purpose, substance, or utility apart from [its] anticipated tax consequence". 60 To address that issue, United States federal courts have developed a two-pronged test for determining whether a transaction lacks economic substance: 61• The objective prong looks at whether the taxpayer has shown that the transaction had economic substance beyond the creation of tax benefits;• The subjective prong looks at whether the taxpayer has shown that it had a business purpose for engaging in the transaction other than tax avoidance. [153] The doctrine has been applied mostly to tax shelters and other closed investments where the taxpayer is not already engaged in the particular subject of the investment, and stands to profit, if at all, only from the particular investments. But54 Ramsay Ltd v Inland Revenue Commissioners [1982] AC 300 (HL).55 Furniss (Inspector of Taxes) v Dawson [1984] AC 474 (HL).56 Inland Revenue Commissioners v Burmah Oil Co Ltd [1982] STC 30 (HL).57 Commissioner of Inland Revenue v Challenge Corporation Ltd [1986] 2 NZLR 513 (PC).58 Barclays Mercantile Business Finance Ltd v Mawson (Inspector of Taxes) [2004] UKHL 51, [2005] 1 AC 685.59 Inland Revenue Commissioners v Scottish Provident Institution [2004] UKHL 52, [2004] 1 WLR 3172.60 See for example Goldstein v The Commissioner 364 F 2d 734 (2d Cir. 1966).61 The leading case here is perhaps still Frank Lyon Co v United States 435 US 561 (1978).US federal courts have essentially created an implicit exception for tax motivated transactions closely tied to ordinary business operations.62 The reasoning appears to be that the rule allows taxpayers to take advantage of loopholes that naturally present themselves in the course of business operations. That will undoubtedly be expensive to the federal coffers, but in economic terms that cost will be limited to the number of "naturally present" loopholes. But what cannot be allowed is an approach that allows taxpayers not only to take advantage of loopholes, but to in effect manufacture circumstances in which they arise. That would be ruinous to the revenue, and wrong. [154] To summarise: taxation litigation involving the economic effect of something routinely involves disputes over the text, intent, or purpose of the statute. The taxpayer will generally defend her position by arguing that the disputed transaction issupported by the statute's text, and in some cases, the intent and purpose. But, as with respect the Supreme Court of New Zealand has identified, the ultimate and particularly challenging question is: "were the benefits arising from the avoidance transaction intended by Parliament?" (My words, emphasis added.) [155] In such an analysis, the language of the statute can be difficult. Lord Hoffman seems to have thought that making a distinction between terms of art and terms of life, is a "not ... unreasonable generalisation" in some cases. 63 But, and this was His Lordship's crunch point, it should not provide a substitute for a close analysis of what the statute means. To put this another way, the extent to which the economic substance doctrine is relevant in an anti-avoidance analysis depends on the Court's interpretation of the legislative purpose. Or yet again: the narrower the view one takes of the legislative purpose, the less relevance there is in the economic substance doctrines. [156] To revert to the instant case, it is useful to start with another of the succinct observations of Learned Hand J in Gregory v Helvering, as to the choice principle: 6462 See for instance UPS v The Commissioner 254 F 3d 1014 (11 th Cir 2001).63 See Barclays Mercantile Business Finance Ltd v Mawson (Inspector of Taxes) at [38].64 At 810.[A] transaction, otherwise within an exception of the tax law, does not lose its immunity, because it is actuated by a desire to avoid, or, if one chose, to evade, taxation. Anyone may so arrange his affairs that his taxes shall be as low as possible; he is not bound to choose that pattern which will best pay the Treasury; there is not even a patriotic duty to increase ones taxes.[157] But in this case, the intertwined economic and commercial effects of what was done, in their proper legislative context, seem to me to be as follows: (i) Income derived from personal exertion should belong in its appropriate taxation band – here the highest band – in a graduated personal tax scheme. It should not be inappropriately diverted away. (ii) These doctors were in the top personal tax rate as a result of their personal skill and exertion. (iii) When Parliament increased the top tax to 39 per cent the doctors deliberately took themselves out of that category by interposing a company/trust structure. (iv) Very significantly, they retained control over the whole of the income generated (notwithstanding the company/trust structure). (v) They then applied the income so earned for the benefit of themselves and their families. (vi) Their salaries were fixed at artificially low levels which did not on any view of the matter conform with anything approaching economic reality. [158] If these propositions are accepted this case is incontrovertibly one of tax avoidance. [159] Some comments are appropriate with respect to proposition (i), above. That issue turns on the overall Parliamentary intent and scheme. The creation of wide taxation "bands" is the driver which gives rise to the circumstances in which band-shifting becomes attractive to taxpayers. Did Parliament intend that individual taxpayers could "band-hop", as these respondents did, by interposing other legally cognisable vehicles in response to tax band alterations? As Randerson J has demonstrated, this case was a direct and immediate response to a recently enlarged tax rate. [160] The answer, or so it seems to me, is to be found in the very structure of the legislation itself, or as it is sometimes put, the scheme of the Act. The New Zealand legislation before us has a graduated rate structure. It is one of the most elemental features of that legislation, which rests on facets of public policy (including social justice) which Parliament saw to be very important. Artificial endeavours to avoid that structure have been firmly discouraged by this Court in a long line of cases on income splitting, stretching from Elmiger & Another v Commissioner of Inland Revenue65 to Hadlee and Sydney Bridge Nominees Ltd v Commissioner of Inland Revenue66 and beyond. There are other cases in which arrangements that shift income from the personal (and particularly professional) exertions of a taxpayer to some other related party have constituted tax avoidance. As only two (well known) examples in the law reports, see Halliwell v Commissioner of Inland Revenue67 andWisheart v Commissioner of Inland Revenue.68[161] So viewed, this case is yet another obvious example in that long line of cases since the 1960's in which taxpayers have patently sought to avoid their lawful taxpaying obligations by a rather obvious, indeed blatant, stratagem. [162] Finally, Courts exist to resolve particular controversies. Much as professional advisers may yearn for all-encompassing templates, to ask courts to attempt to anticipate other possible situations and produce clear, bright-line rules is undesirable and impracticable in taxation law. The function of the Court is to see that the legislative purpose of Parliament is not overtaken by "merely clever" manipulation of particular rules, as happened in this case. And the Court can only determine one case at a time.65 Elmiger v Commissioner of Inland Revenue [1966] NZLR 683 (SC).66 Hadlee v Commissioner of Inland Revenue [1991] 3 NZLR 517 (CA).67 Halliwell v Commissioner of Inland Revenue [1978] 1 NZLR 363 (SC).68 Wisheart v Commissioner of Inland Revenue [1972] NZLR 319 (CA).ELLEN FRANCE J[163] It is trite, but worth repeating, that not all arrangements which produce a tax advantage will constitute tax avoidance. That is the corollary of the freedom taxpayers have to structure their tax affairs in the most tax effective way. I have concluded, contrary to the decision of Hammond and Randerson JJ, that, while the arrangements entered into by Messrs Penny and Hooper do produce a tax advantage, they do not amount to tax avoidance. I write separately to explain why I would therefore dismiss the appeal. [164] I have had the advantage of seeing in draft the judgments of Hammond and Randerson JJ. The judgment of Randerson J sets out the factual background and the issues raised by the appeal which do not need repeating. For that reason, and because I agree with MacKenzie J's approach, I can be brief. [165] Essentially I agree with MacKenzie J, for the reasons the Judge gives, that neither the formation of the companies with the resultant change in the incidence of tax nor the salary arrangements 69 were inconsistent with the scheme and purpose of the Income Tax Act. 70 Applying the "scheme and purpose" approach in Ben Nevis, the tax change effect is not one to which s BG1 is directed. [166] There are three specific matters which seem to me important to the approach taken by Hammond and Randerson JJ that I want to address. [167] The first of these is the effect of the PSA Rules. I agree with Randerson J that the fact the arrangements do not fall foul of the PSA Rules is not determinative. 71 That is plain from the authorities cited by Randerson J.72 I do, however, see the PSA Rules as of some importance.69 I agree with the conclusions of Randerson J at [85] as to the ability of the Commissioner to rely on the advances to Mr Penny.70 See in particular at [44] and [61].71 At [95], above.72 At [93] – [94], above.[168] The Supreme Court in Ben Nevis made the point that the "presence" in the legislation of s BG1 suggests it was intended to be the "principal" means by which tax avoidance is dealt with but not that it is the only means. 73 In the present case, it seems to me that the PSA Rules are relevant when considering notions of artifice or contrivance. The obvious point is that what the taxpayers here have done has not required particular "ingenuity" such that Parliament could not have contemplated the use of company structures in this way. 74 Despite that, the PSA Rules proscribe only a narrower ambit of cases in which income is attributed from the company to the employee. They do not affect the use of company structures by these taxpayers. [169] I add that I do not see the legislative history of the PSA Rules as inconsistent with my approach. [170] The second matter I wish to address is the effect of Hadlee. Randerson J says that the issues discussed by Richardson J in Hadlee indicate that the adoption of structures "which have the effect of diverting or splitting income generated by the personal exertions of individuals" are relevant to the consideration of "whether the arrangements are within Parliamentary contemplation in the sense discussed inBen Nevis". 75[171] I do not agree that Hadlee supports a general proposition to this effect. As MacKenzie J says, Hadlee dealt with the assignment of income. This case deals with derivation of income and the concepts are different. 76[172] This is not a case of income splitting. Both Mr Penny and Mr Hooper sold their business to the companies and goodwill payments were made in both cases.Hadlee is discussing the "personal exertions" of the taxpayer, which in this case must be the exertions of the company, absent any suggestion the company is a sham. [173] The final matter I deal with is the conclusion that the salaries were "so far removed from commercial reality as to be contrived and artificial" and not "within73 At [103].74 At [94], above.75 At [106], above.76 At [36].the acceptable limits of commercial practice". 77 The two features identified in the judgment of Randerson J as relevant to this conclusion are the quantum of the salaries and the taxpayers' control over them. I do not see either feature as amounting to artifice or contrivance. [174] Mr Shewan's evidence about tax practice is relevant here, in particular, his evidence that the concept of a commercially realistic salary is not a familiar one in the context of a family company like those of Messrs Penny and Hooper. This goes to the question of artifice or contrivance and suggests that, contrary to the Commissioner's contentions, what occurred here was consistent with acceptable commercial practice. [175] I should note here that no issue is taken with Mr Shewan's expertise and, while I agree with Randerson J78 that his evidence on various legal issues was not admissible, I consider the evidence on which I rely, which relates to tax and accounting practices, was properly admitted. [176] Mr Shewan in his written brief described the practice of working hard over long periods for minimal rewards in terms of employment income for family-owned companies as the "classic kiwi model" for owner-operated businesses. He continued:It is often the case that the principal family person working in such a company does not derive close to what the Commissioner would treat as being a [commercially realistic salary]. Such businesses are of enormous variety but, for present purposes, examples such as farms, builders, electricians and plumbers, corner dairies, engineers, surveyors, IT consultants, pharmacies, and different types of manufacturing, come readily to mind.[177] Mr Shewan explained that the payment of a less than commercially realistic salary arises because the family company faces one or more of a number of circumstances. A number of those circumstances are not relevant, for example, the companies in question here are not in start up or development mode. But Mr Shewan also describes family companies which are profitable and can pay but77 At [122], above.78 At [97], above.where the person in Messrs Penny or Hooper's shoes does not require a commercially realistic salary. The common examples Mr Shewan gives are as follows:(i) a desire not to accumulate further assets in a person's own name due to asset protection concerns such as exposure to negligence claims, creditors or matrimonial property disputes; (ii) a wish to distribute profits by way of dividend to the Family Company's shareholders (often a family trust) so that they can accumulate and be used to fund school and university education of beneficiaries; (iii) a keen-ness to accumulate assets at shareholder level (generally a family trust or spouse) to take them outside of the ambit of assets that may be called on if personal guarantees that are typically required by banks in support of bank funding into a Family Company are triggered;[178] Both taxpayers gave as one of their reasons for adopting a corporate structure the first of the reasons articulated by Mr Shewan. Both said they saw it as assisting in reducing their exposure to potential claims. While their reasoning in this respect is somewhat slight, the Judge did accept their evidence that this was a genuine motive, along with others, for the choice made. 79[179] It is in the context of considering whether what occurred was an artifice or contrivance that MacKenzie J was correct, in my view, to treat Loader as of significance. Two points emerge from Loader. First, Cooke J saw the type of inter- relationship between trust and company in that case as an "everyday" element in business and family dealings. The proxy here is the taxpayers' "control" (to use the Commissioner's word) over their salaries. Cooke J put it in this way: 80A joint operation is very natural in family dealings. Nor is there anything novel in the concept that one man may be involved in business affairs in a number of capacities: the separate legal identities of company and shareholders and the separate legal existence of trusts are everyday elements in business and family dealings.[180] The second point made by Cooke J follows from the first, and questions the Commissioner's view that it was artificial for one person to have control of the79 At [46].80 At 478.administration of trust and company and yet be carrying on business in much the same way as before incorporation. Cooke J said:81Having regard to the familiar concepts of the separate identities of companies and trusts already mentioned, the situation does not appear abnormally artificial. Moreover, it would have been natural for the objector to retain day-to-day control to the extent enabled by the arrangement, even if the arrangement had been totally unconnected with any tax advantages.[181] The "everyday" nature of what occurred here coupled with the range and variety of businesses using, broadly, the same corporate structure and approach to the setting of salaries must be of some significance in assessing the effect of the transaction. That is not to say, of course, that because "everybody does it" it is not tax avoidance but it may point to what is acceptable business practice and the opposite of artifice or contrivance. [182] In terms of artifice or contrivance, it must also be relevant that Mr Penny was operating his business in this way prior to the change to the company tax rate. While in 1999 the company paid out more, in 1998, prior to the tax rate changes, Mr Penny's company derived taxable income of $299,365.17 but paid out only $83,333.00 as salary and $100,635.00 as a director's bonus to Mr Penny. [183] The latter point does highlight a matter raised by Mr Harley which I think has some force, namely, that there is an element of assessment with the benefit of hindsight by the Commissioner ie not by reference to the arrangement but by reference to "subsequent conduct". 82 Both taxpayers accept that what occurred was an "arrangement" in terms of the Act but there is something a little odd about the position in terms of s BG1 altering on an annual basis depending on the decision made about the salary to be paid and the related resolution to that effect. Perhaps a better way of putting the concern underlying this point is the potential uncertainty for taxpayers because what they do in one year may be within acceptable bounds but a different position may pertain in the next.81 At 479.82 Ashton v Commissioner of Inland Revenue [1975] 2 NZLR 717 (PC) at 722.[184] In all, I do not consider the taxpayers have gained the benefit of specific provisions in an artificial or contrived way. Rather, they have taken advantage of the difference in the tax rates in a way that is within the limits of acceptable commercial practice. [185] For these reasons, I consider MacKenzie J was correct in concluding the taxpayers' arrangements did not fall on the tax avoidance side of the line.Solicitors: Crown Law Office, Wellington for Appellant