BEACHAM v THE COMMISSIONER OF INLAND REVENUE [2014] NZHC 2839

BEACHAM v THE COMMISSIONER OF INLAND REVENUE [2014] NZHC 2839 [14 November 2014]IN THE HIGH COURT OF NEW ZEALANDWELLINGTON REGISTRYCIV-2014-485-7319[2014] NZHC 2839UNDER the Income Tax Act 2004 and the TaxAdministration Act 1994BETWEEN GREGORY MARC BEACHAM ANDVILMA AMELIA BEACHAMAppellantsAND THE COMMISSIONER OF INLANDREVENUERespondentHearing: 13 October 2014Counsel: R J Cullen for AppellantsH Ebersohn for RespondentJudgment: 14 November 2014JUDGMENT OF GODDARD JThis judgment was delivered by me on 14 November 2014at 3.30 pm, pursuant to r 11.5 of the High Court Rules.Registrar/Deputy RegistrarSolicitors:Brett Carpenter, Waiheke Island for AppellantsCrown Law, Wellington for RespondentIntroduction[1] This is an appeal from the decision of Judge Sinclair sitting as Taxation Review Authority (the Authority). The appeal is brought by Dr and Mrs Beacham1pursuant to s 26A of the Taxation Review Authorities Act 2004 and Part 20 of the High Court Rules.[2] The grounds of appeal are that the Authority has failed to apply the tax avoidance sections BG 1(1) and (2) and GB 1 (1) and GB 1(3) of the Income Tax Act2004 (the ITA 2004) correctly to the facts of the appellants' case, by creating aliability for income tax for the appellants where it is contended no such liability properly existed. Broadly, the issues are first, whether the Commissioner's reconstruction of the appellants' 2007 income tax assessments was outside the scopeof her powers; and second, whether the imposition of shortfall penalties was incorrect.The agreed statement of facts and issues[3] An agreed statement of facts was submitted to the Court, together with a bundle of documents. The salient features of the background to this proceeding can be summarised under three headings: the facts before the restructuring of theappellants' companies; the restructuring itself; and the effect of the restructuring.The facts before the restructuring[4] Beacham Holdings Ltd (Beacham Holdings) was incorporated in 1991 as Beacham Cars Ltd. Dr Beacham was the sole director and held 296,000 shares. Andrew Rafferty held the remaining 4000 shares. On 30 October 2000 Mrs Beacham purchased Mr Rafferty's shares.[5] Beacham Jaguar Ltd (Beacham Jaguar) was incorporated in 1994 as Major Trauma Research (New Zealand) Ltd. Dr Beacham and Mrs Beacham each held 50 per cent of the shares in the company.1 Together, the appellants.[6] Dr Beacham was, and is, a medical practitioner and owner of a medical practice. In 1996, he transferred ownership in his medical practice to Beacham CarsLtd and changed its name to Beacham Holdings. Beacham Holdings' medicalpractice was profitable but its car restoration business was not. Beacham Holdings was able to utilise the losses of the car restoration business to reduce or eliminate the assessable income of the profitable medical practice. In 2000, Major Trauma Research (New Zealand) Ltd changed its name to Beacham Jaguar; and later that year Beacham Holdings transferred its car restoration business to Beacham Jaguar.[7] Dr Beacham and Mrs Beacham operated a current account with Beacham Holdings which funded their living expenses. By November 2006 Dr Beacham'scurrent account with Beacham Holdings was overdrawn by approximately $1,079,657.60.Facts in respect of the restructuring[8] Beacham Holdings returned a taxable profit of $558,047.15 in the 2007 year and the company retained profits of $1,856,277.19. These profits were available to be paid as a dividend to the appellants if the directors declared the dividend should be paid. The dividend would be taxable as income.[9] In August 2006 Dr Beacham and Mrs Beacham sought tax advice from their accountant. A tax consultant was commissioned and he proposed a restructure, comprising the following elements.[10] A shell company, Beacham Group Ltd (Beacham Group) would be incorporated, in which the appellants would be directors and 50/50 shareholders. They would then sell their shares in Beacham Holdings to Beacham Group for $1.84 million. Beacham Group would record the cost of its purchase of the shares as an on demand interest free loan by the appellants to Beacham Group. The key element of the arrangement was for relevant journal entries to be made to effect thecrediting of the appellants' current accounts with Beacham Holdings and Beacham Group, thereby partly repaying the loan granted by the appellants to Beacham Group. In effect, instead of Beacham Group repaying the appellants directly, Beacham Group would take over the liability of Dr Beacham to Beacham Holdings.Instead of Beacham Group having to repay the appellants, it would repay Beacham Holdings; and Dr Beacham's liability to Beacham Holdings would be extinguished.[11] The appellants would then treat the amounts received from the sale of their shares in Beacham Holdings to Beacham Group as capital in nature and as repayment of their shareholder current account liabilities in Holdings and Beacham Group.[12] In a letter dated 31 August 2006, the tax consultant recorded the following objective for the restructuring:The aim is to offset Mr and Mrs Meacham's (G&V) value of the shares against the overdrawn current account in Beacham Holdings Ltd [13] The appellants followed this advice and formed Beacham Group. On 1 February 2007 they each sold their shares in Beacham Holdings to Beacham Group for a combined total of $1,840,000.2 Beacham Group recorded the cost of its purchase of the appellants' shares in Holdings as an on demand loan by theappellants to Beacham Group. Payment for the sale of shares was made by means ofvarious journal entries that operated to credit the appellants' current accounts inBeacham Holdings in the amount of $1,213,900; and the share transfers wereeffected. The balance of the purchase price for the appellants' shares in BeachamHoldings was recorded in Beacham Group's financial statements as a loan repayableto the appellants by Beacham Group upon demand. This amount could be accessed in future as a repayment of loan capital (that is, it would not be income under the Income Tax Act 2007 (the ITA 2007)).The effect of the restructuring[14] Dr Beacham returned taxable income of $49,023.98 in the 2007 tax year. The Commissioner's assessment was that he should have returned taxable income of $916,523.00 for that year, comprising $49,023.98 and $867,000 (half of the $1,735,000 purchase price for the shares). The assessed tax shortfall is $337,666.38.2 At the hearing before the Taxation Review Authority on 21 March 2014 the Commissioner conceded that $105,000 of the $1,840,000 was not attributable to the disputants as income, reducing the amount of $1,840,000 to $1,735,000.Mrs Beacham returned taxable income of $40,061.75 in the 2007 tax year. The Commissioner's assessment was that she should have returned taxable income of $907,561.00, comprising $40,061.75 and $867,000. The assessed tax shortfall is $337,128.66.[15] The parties agree that the arrangement outlined above was a tax avoidance arrangement to which s BG 1 of the Act applies. In 2012 the appellants commenced a proceeding in the High Court against Markhams and Tax Assist Ltd regarding the advice provided in relation the restructure of their companies.[16] Their income in the 2007 tax year was assessed by the Commissioner on the basis that: the amount of $1,735,000 received by them from Beacham Group was deemed to be a dividend under s GB 1(3) of the ITA 2004; or alternatively, theamount received would be reconstructed as the appellants' income under s GB 1(1)of the ITA 2004. The Commissioner also imposed shortfall penalties for taking an abusive tax position under s 141D of the Tax Administration Act 1994.[17] Judge Sinclair upheld the Commissioner's reconstruction and the shortfallpenalties imposed.The position of the parties[18] The appellants' position is that there was no need for any reconstruction of their income for the 2007 tax year. They say that s BG 1 has voided the arrangement and thereby eliminated any tax benefit. The Commissioner's position is that the reconstruction was within the scope of her powers.The primary ground of appeal[19] The appellants' primary ground of appeal is that the Commissioner exceeded the scope of her powers by exercising her powers of reconstruction. The power to reconstruct under s GB 1(1) is constrained by BG 1(2). In other words, theCommissioner can only reconstruct so as to counteract a tax advantage "that a person has obtained from or under a tax avoidance arrangement". That is the first issue to be determined. Provided that such a tax advantage existed, the Commissioner hadthe option of basing her assessment on s GB 1(3) or s GB 1(1). Accordingly, for the appellants to succeed on appeal, they must establish that the Commissioner could not reasonably reconstruct under either s GB 1(1) or GB 1(3).Was there an outstanding tax advantage notwithstanding the effect of BG 1(1)?[20] Section BG 1 is the general anti-avoidance provision that was contained in the ITA 2004. It provided:BG 1 Tax avoidanceAvoidance arrangement void(1) A tax avoidance arrangement is void as against the Commissioner for income tax purposes.Reconstruction(2) Under Part G (Avoidance and non-market transactions), the Commissioner may counteract a tax advantage that a person has obtained from or under a tax avoidance arrangement.[21] Section BG 1 entitles the Commissioner to completely disregard the arrangement and any ensuing transactions, so far as they have the purpose or effect of avoiding tax. Disregard of some tax arrangements is sufficient to negate the tax advantage achieved by the taxpayer. For other arrangements however, it may be necessary for the Commissioner to use Part G to counteract a tax advantage obtained from or under a tax avoidance arrangement by using her powers of reconstruction.[22] The central issue is whether an outstanding tax advantage existed in this case, notwithstanding the tax avoidance arrangement was void as against the Commissioner for income tax purposes.[23] Mr Cullen submitted that no such advantage exists, because the current account loans from Beacham Holdings which the appellants used to fund their living expenses remain payable by them for income tax purposes. He argued that Dr Beacham will still need to repay the amount owing on the current account balances; and that the funds he receives to enable him to make those payments will be subject to tax.[24] The difficulty with that proposition is that s BG 1(1) operates to void thearrangement only "as against the Commissioner for Income Tax purposes". Thearrangement is not void as between the parties to the arrangement. For this reason, the debt between Holdings and Dr Beacham was repaid by the crediting of the current account. The tax avoidance arrangement had the effect of repaying DrBeacham's overdrawn account in Beacham Holdings and leaving the balance of the purchase price for the appellants' shares in Beacham Holdings available to beaccessed in future as a repayment of loan capital (and would not be income under the ITA 2007). This is self-evidently a case in which the arrangement being void against the Commissioner did not remove the tax advantage; and thus it was open for the Commissioner to reconstruct the appellants' income tax assessments.[25] The next issue is whether the reconstruction carried out was within the scope of GB 1(3) or GB 1(1).Application of GB 1(3)[26] At the relevant time, s GB 1(3) provided the Commissioner's specific reconstruction powers in relation to dividend stripping arrangements. Under that provision, where there has been a sale or disposal of shares as part of a tax avoidancearrangement in exchange for consideration and, "in the opinion of the Commissioner", that consideration "represents, or is equivalent to, or in substitutionfor, an amount which, if that arrangement had not been made or entered into, the person would have derived or might be expected to have derived, as dividends in that tax year, or in any subsequent tax year, an amount equal to the value of thatconsideration" – an amount equal to the value of that consideration "is deemed to be a dividend derived by that person".[27] The appellants accept they sold their shares in Beacham Holdings to Beacham Group as part of a tax avoidance arrangement. They also accepted there was payment for the sale of these shares by way of crediting. The only element of GB 1(3) that has not been admitted is whether it was reasonably open for the Commissioner to form the view that the consideration received by the appellants forthe sale of their shares in Holdings was "consideration in substitution for a dividend"which the appellants would have derived or might have been expected to have derived.[28] Mr Cullen submitted that the Commissioner's powers are limited to thepowers the company has to declare dividends under company law principles. He suggested Beacham Holdings could not have issued dividends in that amount without being in breach of company law principles.[29] A similar argument to that advanced by Mr Cullen was disposed of by Judge Barber in Case Z4:3[79] The definition of ''paid'' which is applicable to the payment of dividends by companies in the Income Tax Act 1994 is clear. If an amount is credited, then a dividend for the purposes of the Income Tax Act 1994 is paid. A dividend for the purposes of the Income Tax Act 1994 is also derived. The fact that, for company law purposes, there may be a further requirement before the amount so credited can be paid out does not affect that position. If the amount credited should never be paid out, because the company became insolvent, that equally does not affect the income taxposition. The amount credited remains taxable even though never received[80] The concept of what is a dividend for income tax purposes is broader than what constitutes a distribution for the purposes of the Companies Act 1993. For example, transactions with associated persons are caught. That also demonstrates that the operation of the provisions in the Income Tax Act 1994 are not affected by the operation of the solvency test in the companies legislation. That test has a completely different rationale and operation.[30] It is notable also that the Courts and the Taxation Review Authority have recognised that the crediting of a current account, such as occurred here, can be a dividend for tax purposes, because it transfers value. For example, in Q49, Judge Willy found:4I am satisfied that the evidence discloses that the transaction involving the debiting of the capital account and crediting of the shareholders currentaccount and loan accounts does give rise to a deemed dividend[31] As Mr Ebersohn submitted on behalf of the Commissioner, Mr Cullen'sproposition takes no account of the differences between dividends for the purpose of the Income Tax Act regime and dividends under company law. The Companies Act 1993 provides limits on dividends; whereas the focus of the Income Tax Act regime3 Case Z4 (2009) 24 NZTC 14,051(TRA).4 Q49 (1993) 15 NZTC 5,254 (TRA).is to ensure that all transfers of value by the company to its shareholders are caught. As a result, the dividend provisions in the Income Tax Act regime are drafted more widely.[32] Section CD 1 provides that a dividend will be the income of the person who derives it. Section CD 3(1) provides that a transfer of value will be a dividend where the cause of the transfer is a shareholding in the company as described in s CD 5. Section CD 5(2) notes that one indication of a transfer being caused by a shareholding where the terms of the arrangement resulting in the transfer are different from the terms on which the company would enter into a similar arrangement were no shareholding involved. Section CD 4(1) and (2) provide that atransfer of value need only be "money or money's worth", including the release of a debt.[33] In the present case, the purpose and effect of the arrangement was to transfervalue from the appellants' companies to the appellants themselves. Had the value been transferred directly, that consideration would have been a dividend. Axiomatically the arrangement would not have been entered into if the appellants were not shareholders. They received the benefit of the consideration for no economic cost. They still own the shares in Beacham Holdings (via Beacham Group). As Mr Ebersohn submitted, a person who was not a shareholder would not receive a transfer of value on such terms. In conclusion, therefore, I am satisfied that it was reasonably open for the Commissioner to form the view that the consideration received by the appellants for the sale of their shares in Beacham Holdings was"consideration in substitution for a dividend".Section GB 1(1)[34] The alternative basis on which the Commissioner made her assessment is the general reconstruction provision in s GB 1(1). Where an arrangement is void in accordance with s BG 1 and the taxable income of any person is affected by that arrangement, the Commissioner is entitled to adjust the amounts included incalculating the appellants' taxable income "in the manner the Commissioner thinksappropriate, so as to counteract any tax advantage obtained under that arrangement".[35] That general power under s GB 1(1) is supplemented by specific powers vested in the Commissioner under s GB 1(1)(a) and (b), whereby she can have regard to such gross income, allowable deductions and available net losses as she considers the person "would have, or might be expected to have, or would in all likelihood have, had if the arrangement had not been made or entered into"; and alsoto such gross income and deductions as she considers the person "would have had ifthat person had been allowed the benefit of all amounts of assessable income, or of such part of the assessable income, as the Commissioner considers proper, derivedby any other person or persons as a result of that arrangement".[36] In the present case, the Commissioner was entitled to take into account the gross income (by way of dividends) which the appellants would in all likelihood have received had the tax avoidance arrangement not been made or entered into.Conclusion[37] I conclude that the Commissioner had jurisdiction to use the powers under Part G to reconstruct the appellants' 2007 income tax assessment and that it wasreasonable to reconstruct under either GB 1(3) and GB (1).Shortfall penalties[38] The TRA upheld the Commissioner's imposition of a shortfall penalty unders 141D of the Tax Administration Act 1994. The penalty payable for taking anabusive tax position is 100 per cent of the resulting tax shortfall. In the appellants'case, this penalty was then reduced by 50 per cent under s 141FB of that Act.[39] The following requirements must be satisfied in order for an abusive tax position shortfall penalty under s 141D to apply. First, the taxpayer must have taken a tax position leading to a tax shortfall exceeding $20,000. Second, the tax positionmust be an "unacceptable tax position", defined in s 141B as a tax position which, when viewed objectively, fails to meet the standard of being as likely as not to becorrect. Third, viewed objectively, the tax position must have been taken in respect, or as a consequence, of an arrangement entered into with a dominant purpose of avoiding tax.[40] The first two elements are satisfied. When the appellants filed their income tax returns for the 2007 year, they took a tax position.5 For the reasons set out aboveI agree with Judge Sinclair's determination that the consideration received by theappellants from Beacham Group was a deemed dividend under s GB 1(3). I do not therefore accept there was no shortfall arising out of the appellants' tax position. Forboth appellants, the shortfall exceeded $20,000. I am satisfied that the tax position fails to meet the standard of being as likely as not to be correct.[41] The sole issue therefore is whether the arrangement was entered into with adominant purpose of avoiding tax. "Dominant purpose" means the most influential,important, prevailing or ruling purpose.6 The purpose to be assessed is that of the arrangement itself. The motive or intention of the taxpayer is irrelevant.7[42] In this respect it is relevant that the appellants did not lead any evidence to establish any commercial or other purpose for the restructuring of their companies. Mr Cullen submitted that the dominant purpose of the arrangement was simply torestructure the appellants' companies, but he was unable to point to any greater rationale than that.[43] It is also relevant that, as has already been noted, a "dominant purpose" of the arrangement was clearly stated by the appellants' tax consultant as being:to offset Mr and Mrs Meacham's (G&V) value of the shares against the overdrawn current account in Beacham Holdings Ltd [44] The Commissioner pointed also to other features of the arrangement thatindicate a "dominant purpose" of the arrangement was to avoid tax. For instance, the structure of the arrangement meant there was no real or economic cost incurred by the appellants; the appellants retained their shares ownership or control of all the5 Tax Administration Act 1994, s 141D(7)(b).6 Commissioner of Taxation v Spotless Services Ltd [1996] HCA 34, 96 ATC 5201, 5206.7 Ben Nevis Forestry Ventures Ltd v Commissioner of Inland Revenue [2009] 2 NZLR 289, (2009) 24 NZTC 23,188 at [207].relevant companies; Dr Beacham's overdrawn current account with Beacham Holdings was repaid in full; and there were no longer any retained profits in Beacham Holdings available to be paid directly to the appellants. On the basis of the evidence as outlined, I am satisfied that the arrangement was entered into with a dominant purpose of avoiding tax.Result[45] The appeal against the judgment of the Taxation Review Authority upholdingthe assessments for the appellants' 2007 income year is dismissed. The shortfallpenalties that were imposed for the taking of an abusive tax position were correct.Costs[46] The respondent is entitled to costs, which I am minded to impose on a 2B basis plus disbursements. Leave is granted to file short memoranda within seven days, if the parties wish to be heard on the issue of costs.Goddard J