Michael Littlewood: $2b question with no easy answer

So far the courts have ruled in favour of the Inland Revenue Department in cases against the BNZ and Westpac. The ANZ, ASB and Rabobank cases remain to be heard. Photo / Martin Sykes

Tax avoidance has been much in the news recently, because of the banks' cases.

The cases are newsworthy because of their scale: between them, BNZ, Westpac, ANZ, ASB and Rabobank owe about $2 billion in unpaid tax, says the Inland Revenue Department.

Also, these banks are all foreign-owned. Despite the extensive news coverage, many people seem to have only a vague understanding of what the cases are about, but the issues are simple.

There are three key points.

The first is the ancient principle, established by Magna Carta in 1215, that you are only obliged to pay tax if the law requires you to do so.

The second is the general anti-avoidance rule (GAAR), which is a rule against tax avoidance contained in the Income Tax Act. And the third is the "choice principle", which is a rule as to how the GAAR is to be interpreted.

The starting point is the principle that you are only obliged to pay tax if the law requires you to do so.

It follows from this that if you arrange your affairs in such a manner that the Income Tax Act does not apply to you, then you do not have to pay any income tax.

The problem with this is that a taxpayer (or their lawyer or accountant) might invent a method of receiving income in such a way that it is not covered by the act.

In other words, the taxpayer might find a way of avoiding the tax.

For example, the taxpayer might make a profit that it is not covered by the legal definition of income, with the result that it is not taxable.

The problem of tax avoidance is as old as taxes and in the late 19th century, Parliament responded to it by enacting the GAAR (now section BG 1 of the Income Tax Act 2007).

The GAAR provides that if what the taxpayer has done is a "tax avoidance arrangement", the IRD can tax him either (a) as if he had not done it at all, or (b) in whatever manner is necessary to "counteract" the "tax advantage" he would otherwise obtain.

The question, then, is what counts as tax avoidance? One answer might be that tax avoidance is anything that reduces your liability to tax.

But that cannot be correct. For example, you might object to paying tax on your income at 38 per cent; and for that reason, you might give up your job as, say, a lawyer, and work as a ski-instructor instead.

But for the IRD to treat that as tax avoidance, and tax you as if you were still practising law, would be absurd.

Therefore, the GAAR must be interpreted in accordance with the "choice principle" - you can choose to earn a large income (and pay tax at 38 per cent); or you can choose to earn a smaller income (and pay tax at a lower rate) - and this will not count as tax avoidance, even if your only reason for giving up law was to escape the tax.

Another example is the use of trusts. The Income Tax Act provides that trusts are taxed at 33 per cent, whereas personal income over $70,000 per year is taxed at 38 per cent.

Again, therefore, you have a choice: you can hold your investment properties in your own name (and pay tax on the rent at 38 per cent); or you can put them in a trust (and pay tax at 33 per cent).

It is necessary therefore to distinguish between (a) tax avoidance (which is caught by the GAAR) and (b) tax mitigation (meaning transactions which reduce a person's liability to tax, but which do not count as avoidance, even if carried out for no other purpose than to escape tax, and which are not caught by the GAAR).

How, then, does all this apply to the banks? Each of the banks conducted a series of transactions, referred to as "structured finance" transactions.

These transactions were essentially loans structured in such a way that (a) the several billion dollars in interest received by the banks was (according to them) not taxable, even though (b) the several billion dollars of expenditure they incurred was (according to them) deductible.

It is crucial to appreciate, however, that producing tax-free profits was not the point of the exercise.

Rather, the banks' aim was to reduce the tax they would otherwise have to pay on their other income (home-loan interest, credit card interest, etc), by deducting from that income the expenditure incurred in connection with the structured finance transactions.

The IRD maintains that the transactions constitute tax avoidance; that they are caught by the GAAR and that the banks are therefore not entitled to the deductions they claim.

Given that the only purpose for which the transactions were carried out was (as found by Justice Wild in the BNZ case and by Justice Harrison in the Westpac case) to reduce the banks' liability to tax on their other income, the IRD's argument might seem self-evidently sound.

But that is to forget the choice principle - for the banks' position is essentially that the rules under which they claim the deductions were enacted so that taxpayers could choose to use them; that they used the rules as Parliament intended; that the transactions were tax mitigation, not tax avoidance; and that the GAAR therefore does not apply.

Which argument is correct is the question the courts have been called upon to answer. So far, the IRD (with wins in both the BNZ and Westpac cases) leads by two to nil, but the ANZ, ASB and Rabobank cases remain to be heard, and it seems probable that there will be appeals to both the Court of Appeal and the Supreme Court, so it will be some time yet before we know the answer.

Several other points are worth making.

First, the banks and their advisers have blamed their problems on an alleged lack of clarity in the law. They have claimed, too, that this lack of clarity deters investment.

But these complaints deserve no sympathy, for the law relating to tax is no less clear, and probably much clearer, than other areas of the law; and there is no reason why people seeking to escape tax should get any more clarity than anyone else.

More importantly, it would be naive to think that rewording the legislation would reduce the problem. No matter what the legislation says, some taxpayers will attempt to escape tax, and the courts will have to decide whether they should be permitted to get away with it.

Every tax system in the world faces this problem, and New Zealand's legislation is in this respect as good as any other country's.

As for the claim that the alleged lack of clarity in the law deters investment, it would be a mistake to take it seriously.

No doubt there are aspects of the tax system that deter investment; but lack of clarity in the rules relating to avoidance is not one of them.

There are many cases in which the IRD has sought to defeat taxpayers' attempts to avoid tax, but in all of them, including the banks' cases, the taxpayer was plainly trying it on.

That is, the taxpayer went out of his way to escape tax - and people who sail too close to the wind deserve no sympathy if they get wet.

It is likely that the GAAR deters tax avoidance; that is, indeed, its function.

But there is no evidence that it deters real investment.

The IRD has not accused the banks of behaving criminally. All that has happened is that the IRD has assessed the banks to tax (on the basis that they are not entitled to the deductions), and the banks have claimed that the amounts of the assessments are incorrect (on the basis that they are entitled to the deductions).

The banks have not been accused of evasion (lying about how much income you have made, which is a criminal offence), but only of avoidance (arranging your affairs so as to pay less tax than otherwise might have been payable, which is not a criminal offence).

Whether the banks have an ethical obligation to pay tax is debatable: maximising their after-tax profits is the banks' main function; and helping them to do it is what their advisers are paid for.

Presumably, too, the banks factored in a degree of negative publicity as a price worth paying.

In any event, people who would prefer to use a bank that does not attempt to escape tax are free to do so (though, admittedly, their choice would seem to be rather limited).

Thirdly, there is the likelihood that the courts will require the banks not only to pay the tax they have sought to escape (plus interest for late payment), but to pay penalties, too.

The Tax Administration Act says that a taxpayer can be penalised if he has taken a position that is abusive. The amount of the penalty is the same as the amount of tax avoided. In other words, you have to pay double.

But the question of penalties will arise only if the courts hold that what the banks have done is avoidance, and that remains to be seen because BNZ and Westpac are likely to appeal, and the other banks' cases have not yet come to court at all.

* Michael Littlewood is a member of the faculty of law at the University of Auckland, specialising in tax.