A building is designed with flexibility to move, preserve structural integrity and allow continued function. These features deal with normal events that affect the building. Some buildings are purpose-built with added base isolators to withstand shocks.
Our tax system has similar design features, which allow it to function in a fair and efficient way, and accommodate the day-to-day activities of taxpayers. There is also a base isolator, the General Tax Anti-Avoidance Rule, which comes into play when abnormal shocks threaten the system.
The QWBA item
Debt capitalisations and Look Through Company (LTC) elections are two of four scenarios in a recent Inland Revenue Department (IRD) draft called, ‘Questions We’ve Been Asked (QWBA)’ item. The draft considers both as shocks to the tax system and hence requires deployment of the tax-avoidance base isolator.
In IRD’s view, this is required to preserve the integrity of the tax system.
The draft QWBA allows taxpayers to see how the Income Tax Commissioner thinks Section BG 1 of the Income Tax Act (the General Tax Anti-Avoidance Rule) applies to specific facts and specific cases; and provide feedback on whether the Anti-Avoidance Rule has been correctly applied.
We disagree with the Commissioner’s application of Section BG 1 in a number of areas.
If the Commissioner does not amend the draft (QWBA), taxpayers will have the opportunity to make informed commercial decisions on their options. At a minimum, they will be aware that they have a potential dispute with IRD and will be able to plan and act accordingly. This, at least, is positive.
However, the draft puts a number of standard commercial transactions at the risk of being treated as tax avoidance with uncertainty for existing (and previous) arrangements.
The two scenarios of concern are as follows:
An insolvent company has an outstanding shareholder loan.
The company and shareholder reach an agreement whereby the shareholder purchases additional shares for cash, which the company will use to repay the loan. No taxable debt forgiveness income arises for the company as the ‘debt capitalisation’ allows it to effectively repay the loan.
Directors of a company resolve to sell the business and liquidate with surplus assets distributed to shareholders and make it LTC. The decision has the effect that tax paid reserves are not taxed, while other taxable reserves are taxed at shareholders’ marginal tax rates on transition. Both reserves can then be distributed free from further tax to all shareholders.
The Commissioner considers these as tax avoidance arrangements because there are alternatives that create taxable income.
Under the debt capitalisation scenario, debt forgiveness will create taxable income for the company. For the liquidating company under the latter scenario, liquidation under the normal company rules would mean that 33% tax rate shareholders would have an additional 5% tax liability on the pre-LTC tax paid reserves.
The Commissioner’s analysis is that Parliament has not contemplated the avoidance of these alternative tax liabilities.
The Commissioner’s analysis raises a fundamental issue.
The basic proposition is that a taxpayer can no longer have due regard to the tax consequences of their actions when determining what to do.
In fact, it suggests that taxpayers take action that would result in the highest tax payable.
That is the most concerning feature of the draft as it is a significant change in approach.
For example, if a building is owned through a company, its sale can be achieved by disposing off the underlying asset or shares in the company.
There are different tax outcomes for the shareholder under each approach. I would be surprised if the Courts concluded that a sale of shares constituted tax avoidance as this is an alternative way to achieve the sale of the building.
In the debt capitalisation scenario, debt forgiveness and debt capitalisation (i.e. a debt for equity swap) both achieve the commercial objective of making the company solvent.
It is surprising that the Commissioner does not accept the latter as a legitimate tax way of achieving that objective.
The two scenarios also illustrate the difficulty of applying the Parliamentary Contemplation test. If there is no specific rule that allows or prevents a particular action, there is no clear way to determine whether the result of the action is a standard design feature or one to which the base isolator effects of section BG 1 should apply.
Taxpayers and IRD can provide rational answers to what Parliament contemplated.
This results in significant uncertainty and is unlikely to be clarified by the Courts or Parliament soon.
The debt capitalisation scenario, in particular, suggests to us that the Commissioner has gone too far in her characterisation of how section BG 1 should be applied.
There is an opportunity to provide comment on the draft QWBA.
It should be taken as an effort to persuade the Commissioner that her conclusions are invalid. Otherwise, urgent law changes will be required to allow these transactions to proceed.
Dinesh Naik is Tax Partner at KPMG based in Auckland. KPMG is the Sponsor of the ‘Business Excellence in ICT Category’ of the Indian Newslink Indian Business Awards 2014.